The combination of continued strong economic recoveries and high inflation will push global government debt slightly lower as a share of GDP this year despite fiscal deficits remaining elevated compared with pre-Covid-19 levels, according to Fitch Ratings.

Average annual inflation for rated sovereigns was the highest in more than a decade in 2021, at 3.3%, and is forecast to be 3.2% in 2022. Fitch forecast the median reduction in government debt/GDP ratios that is attributable to inflation this year to be 2.0 percentage points of GDP, matching 2008 for the most significant inflationary effect in more than two decades.

According to Fitch Ratings, a 1% increase in the median for average annual inflation rates to 4.2% would reduce global government debt medians by an additional 0.5 percentage points of GDP, all else equal.

Despite the risk of rising inflation, Fitch stated that inflation pressures will recede in 2022, as goods demand begins to fade and supply bottlenecks ease. Annual average inflation is forecast by the global rating agency to be marginally lower this year.

“Inflation is running higher in emerging markets than in developed markets, but most emerging-market sovereigns have debt denominated in foreign currencies, exposing government debt ratios to risks of currency depreciation that might accompany higher inflation”.
Fitch Ratings

Improvement in primary balances to drive down debt ratios

Fitch believes the reduction of government debt ratios in the years ahead will depend on improvements in primary balances, as real GDP growth slows from post-pandemic recoveries, and real interest rates increase due to the normalization of global monetary policy even as inflation slows.

In nominal terms, Fitch Ratings forecasts global government debt to continue its steady increase in dollar terms, reaching USD88 trillion by end-2022. In contrast, the global government debt/GDP ratio peaked at 93.4% in 2020.

Fitch underscored that debt/GDP ratio has been in subsequent slow decline, based on strong real GDP growth amid Covid-19 recoveries, combined with higher inflation and improvements in primary balances. Rising inflation can have a meaningful effect on government debt/GDP ratios in nominal terms by raising GDP and in real terms by lowering real interest rates (assuming unchanged nominal rates), Fitch explained.

The familiar ‘debt dynamics’ equation, Fitch said, allows for isolation of the inflation effect on debt/GDP ratios and a more detailed analysis. Median year-on-year inflation for Fitch rated sovereigns was 5.5% in December 2021, the highest since 2009, and annual average inflation last year was the highest since 2012, at 3.3% (global median).

High debt levels

In 2020, the world observed the largest one-year debt surge since World War II, with global debt rising to $226 trillion as the world was hit by a global health crisis and a deep recession.

Global debt rose by 28 percentage points to 256 percent of GDP in 2020, according to the latest update of the IMF’s Global Debt Database.

Borrowing by governments accounted for slightly more than half of the increase, as the global public debt ratio jumped to a record high in 2020. Private debt from non-financial corporations and households also reached new levels.

Debt was already elevated going into the crisis, but now governments must navigate a world of record-high public and private debt levels, new virus mutations, and rising inflation.