During the “Great Moderation” that preceded the COVID-19 pandemic, years of low inflation led to the growth of sovereign debt issued at fixed interest rates and long maturities. And now two years of unexpected inflation in the United States has effectively diluted those bonds, in America and elsewhere.
CAMBRIDGE – As developing countries face a new era of high inflation, rising interest rates, a stronger dollar and capital outflows, some governments stand to benefit from a little-noticed windfall. During the “Great Moderation” that preceded the COVID-19 pandemic, years of low inflation led to the growth of sovereign debt issued at fixed interest rates and long maturities. However, two years of unexpected inflation in the United States have effectively diluted this debt.
By our calculations, the US government’s inflationary windfall is substantial. In October 2019, the International Monetary Fund’s World Economic Outlook projected US inflation to be 2.4% in 2021 and 2.3% in 2022. But US inflation hit 4.7% in 2021, and the IMF now expects a rate of 7.7% this year. . The size of what we call the “unexpected inflation shock” over 2021-22 is therefore 7.7% (the sum of actual inflation rates minus projected rates). Under these conditions, the biggest winner will be the biggest issuer of dollar debt: Uncle Sam.
At the end of 2020, long-term fixed-rate US government debt stood at nearly $21 trillion, and the US monetary base (which includes the amount of currency in circulation) was approximately $5.2 trillion. While most of the 2021-22 inflation (12.4%) falls on the monetary base, its unexpected component (7.7%) reduces the value of US government debt, as debt holders are compensated with interest for expected inflation. The US Treasury thus records a huge reduction of $2 trillion – nearly 11% of GDP – in the real value of its $26 trillion in inflation-exposed liabilities. Offsetting the US Federal Reserve’s holdings of long-term Treasuries brings the figure down to 9% of GDP.
According to conventional wisdom, it is mainly developing countries that resort to inflating their debts. But the current period of high inflation in the United States reminds us that developed countries have also often resorted to unconventional strategies such as the “inflation tax” to deal with their debts.
Long-term US Treasury securities totaling about $6.6 trillion are held by foreign entities such as central banks and pension funds, and the Fed estimates that nearly $1 trillion in dollars is also held by non-residents. By diminishing the real value of these holdings, high US inflation has essentially shifted $568 billion from non-residents to the US government, meaning that about a quarter of US inflation tax over the past two years has been paid abroad.
Two of the biggest holders of long-term US Treasuries are Japan ($1.2 trillion) and China ($862 billion), which together paid nearly a third of the gains in the United States. Apart from China and large cash holders like Argentina (which loses an amount equal to 3% of GDP, due to the reduced value of dollar cash held by residents), most of the largest taxpayers in abroad are developed economies.
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But America is not the only winner. Many emerging markets are also benefiting, as a significant portion of their debt is issued in dollars. Since foreign investors have been unwilling to bear the risk of governments trying to dilute the real value of their bonds by printing money and triggering inflation, many governments have tied their hands by issuing dollar-denominated debt.
Bondholders were thus able to ensure that the inflation of the national currency would not negatively affect the value of their holdings – or so they thought. The relative purchasing power parity theory tells us that the nominal GDP of all countries, when measured in US dollars, will eventually grow at the rate of US inflation. High inflation in the United States therefore means that the real burden of dollar-denominated debt will decline, yielding a substantial gain to other sovereigns.
Excluding the United States, the total stock of long-term dollar-denominated fixed-rate debt in 2021 was $1.3 trillion, according to the Bank for International Settlements. So, to get a conservative estimate of the size of the gain for non-US governments (conservative because US inflation could beat forecasts or persist beyond this year), we can apply 7.7% unexpected inflation to $1.3 trillion, which implies savings of about $100 billion. Due to the dilution of their debt, Turkey, Indonesia, Mexico, Saudi Arabia and Brazil each receive a one-time transfer that exceeds $4 billion, at the expense of their creditors. Other big winners (in relative terms) include developing countries like Lebanon, Venezuela, Jamaica and Mongolia, whose governments also benefit from 2% of GDP or more.
Certainly, these astronomical sums will cause creditors to demand higher interest rates on new debt issues. But higher interest rates do not affect the plummeting real value of the existing stock of long-term debt. For some countries, the effect of this transfer may also take time to be felt, as the dollar has recently strengthened against other currencies. But the recent inflation shock in the United States is a monetary shock, implying that nominal exchange rates will ultimately move with the inflation differential between countries (in line with relative purchasing power parity theory ). Once they do, the GDP of other countries, when measured in dollars, will also rise at the rate of US inflation, ensuring that the real burden of sovereign debt declines.
Commentary on the perils facing developing countries tends to focus on the risks posed by rising interest rates and depreciating currencies. For governments, however, US inflation also comes with a silver lining: bondholders pay the price while inflation eats away at a massive stockpile of sovereign debt.