In response to the Covid-19 shock, global public debt will hit an all-time high of 130% of GDP or USD277trn in 2020, exceeding even the levels seen during the Second World War. This won’t be without consequences for debt sustainability, particularly for the most fragile economies in the European periphery. Today’s conventional wisdom tells us that governments benefit from a quasi-infinite capacity to issue debt when facing a systemic shock, especially with the support of central banks resolutely engaged in unconventional monetary policy. Accordingly, the Covid-19 crisis has sparked a strong and globally synchronized increase in public debt, particularly in advanced economies, to smooth the negative impact of lockdowns. At the same time, central banks have pursued unconventional monetary policies, mainly involving government bonds purchases, with their balance sheets converging above 50% of GDP at the end of 2020. This is simultaneously allowing a quasi-direct financing of world public debt.

These common factors seem to have compressed risk premiums and created a spirit of complacency regarding the sustainability of world public debt. Over the last few years, government bond yields have been evolving at a very low level, while spreads between countries, a mirror of the relative risk of default, have trended on the downside despite the risky behavior of debt accumulation. European debt spreads in particular have recently reached record low levels following the initiative to create a pool of common debt via the European Recovery Fund. In our view, there is a non-negligible probability to see those spreads increase again in the near future, even if a rapidly rising common pool of global sovereign debt and direct purchases of government bonds by central banks have significantly altered the capacity of investors to distinguish between viable and non-viable regimes of debt accumulation.

The question is therefore the following: rather than the absolute level of public debt, expressed as a percentage of GDP, is it rather the deviation from a common trend of debt accumulation that leads to a widening of government bond spreads? In this case, in a context of a generalized inclination to issue much higher public debt, and where central banks tend to prevent interest rates from increasing too rapidly, one could think that there is a lower risk for governments to face the sanction of the market. This implicitly tests the assumption that Europe will be stronger in issuing a common pool of public debt.

To study this question, we build a model allowing us to identify the common and specific determinants of debt issuance across countries to see if only the specific components (that we could associate with a deviation from a trend of higher public debt at a global level) have an influence on government spreads.

The first conclusion is that the common factor of public debt supplies (the global trend) is significant (with a lag of four quarters) for all countries in explaining sovereign spreads, with higher beta for the European periphery. The second conclusion we draw is that the U.S. 10-year interest rate has a higher impact on European spreads than national specific factors of debt. The third conclusion is that specific factors of the U.S. and Germany’s public debt supply are strongly significant in explaining all EMU sovereign spreads. Finally yet importantly, specific factors of periphery countries’ public debt have a low explanatory power (are not significant for the Spanish and Portuguese cases) in explaining spreads, meaning that those countries could face high difficulties in stabilizing their government bond yields even when being determined to stabilize public debt. 

There is therefore no place to hide. Even times of generalized complacency in public debt issuance are likely to trigger a surge of risk premia for those countries that are structurally the most fragile. An austerity shock, especially in the U.S. but also in Germany, that would act as sudden stop in the supply of safe assets, or an unexpected disruption of the smoothing function of unconventional monetary policies could have a destabilizing effect on the stability or sustainability of the European periphery’s public debt via a significant widening of sovereign spreads.