The world has entered uncharted territory in terms of the debts burdening major economies. Seven major economies are carrying debts more than their annual GDP, which has never happened in combination with such high interest rates. Their currencies are ripe for a series of devaluations reminiscent of the Asian and Russian financial crises of the late 1990s but on a much larger scale.
The International Monetary Fund (IMF) estimates that Canada, France, Italy, Japan, Spain, the United Kingdom, and the United States are all carrying debt equal to more than 100 percent of their GDP. Most of this “D-7” group borrowed heavily during the global financial crisis and again during the COVID-19 pandemic. Japan has been swimming in debt for a quarter century. Yet in terms of the D-7’s reliance on global credit markets, things are at their worst now.
A more precise measure of the D-7’s ability to repay what it owes is the ratio of debt net of financial assets to GDP. By this metric, Canada is in somewhat better shape than the rest. But for the group, the ratio sits at an estimated 100 percent this year, and it has never been greater at a time when interest rates have also been so high. Even in the aftermath of the Great Recession, the ratio was lower. And even though the ratio was somewhat higher at the beginning of the pandemic, interest rates were at rock bottom back then.
Indeed, interest rates on bonds issued by the D-7 have risen by hundreds of basis points during the past three years. Further pressure on the credit markets, wherever it comes from, will make borrowing more difficult for all of them. Risks will deepen for investors, as well, since yields on the securities issued by the D-7 tend to move in parallel. Trillions of dollars in securities are tightly linked, and one domino falling could knock them all down.
That domino is likely to be the first in a series of currency devaluations, triggered either by speculating investors or by the governments themselves. Because the D-7 countries issue debt in their own currencies, they can control the value of their liabilities. Devaluing their currencies—usually by flooding the market with it and generating inflation—makes their accumulated debts smaller relative to their current tax revenues. It’s a clever trick that avoids the messy politics of cutting spending or raising taxes.
This has happened in the not-too-distant past, when major economies were struggling with high levels of debt, trying to head off speculation about their currencies, or both: France in the 1950s, the United Kingdom in the 1960s, and Italy in the 1990s.
But investors can also be the ones who put a devaluation in motion. If they think a country will soon suffer rapid inflation, or that its bonds might not be repaid, or that it will initiate a devaluation itself, then they will start selling its securities and currency in the open market. After all, a devaluation will destroy the value of the securities in investors’ portfolios. So as soon as they suspect a devaluation is coming, they have an incentive to sell any assets denominated in that currency.
Events like this can start without warning and accelerate at a breakneck pace, leaving governments scrambling to refinance their debts. If the devaluation turns into a rout, central banks usually need to step in and deploy their reserves to buy up their own currencies. But in the meantime, uncertainty drives interest rates skyward, making borrowing even more difficult.
None of this would be such a huge problem for the global economy if the devaluation were confined to a single country, even to a major economy. But any devaluation would likely spread, thanks to at least three mechanisms.
One is the classic beggar-thy-neighbor dynamic. When the United Kingdom devalued in 1967, Spain, Portugal, Ireland, and several other countries quickly followed suit. They didn’t want their exporters to be at a disadvantage with one of their most important trading partners. So, they essentially restored the same terms of trade as they had before. If the United States were to devalue the dollar sharply—say, by cutting interest rates and deliberately causing higher inflation—then countries like Canada, Mexico, and China might follow suit.
Devaluations also tend to spread because of the behavior of investors themselves. When there is a significant repricing of an asset in large investors’ portfolios—as there would be with a devaluation—investment managers tend to reassess the risks of other similar assets. For instance, a devaluation of the U.S. dollar might lead managers to conclude that Canadian securities were also riskier, even putting aside the countries’ trading links.
This behavior can lead managers to trim their holdings of an entire class of similar assets, so one devaluation causes a sell-off that affects several countries. It happened in East Asia in 1997 and Russia in 1998. Investors began to doubt the value of several currencies and, one after another, pulled money out. All the countries devalued, and only Russia actually defaulted on its debt. Bailouts followed, governments imposed austerity measures, and living standards tumbled. In South Korea, GDP per capita fell by a third in dollar terms between 1997 and 1998.
Back then, the sudden collapse of so many currencies took the markets by surprise. Investors failed to understand how correlated their risks were; their portfolios were not diversified enough to avoid disaster. The Asian and Russian crises ended up pulling down Long-Term Capital Management, then one of the world’s biggest hedge funds. This time, with much bigger economies involved, more giants might fall.
A third source of contagion is specific to the major economies and was thus absent from the Asian and Russian crises. Because the big central banks hold securities denominated in each other’s currencies, the devaluation of any single one of them could reduce the value of all their reserves, weakening their ability to defend their own currencies from speculation. To be sure, the U.S. Federal Reserve has relatively small holdings in euros and yen, but dollar and euro holdings by the other central banks are much larger.
The thorniest situation could develop, just as it did during the last global financial crisis, among the countries that share a central bank. In the euro area, not every country would necessarily support a devaluation. Germany is in a much better fiscal position than France, Italy, and Spain, and it has little taste for the inflation associated with a cheaper euro. So, like Greece in 2010, France, Italy, and Spain could be forced to seek bailouts to refinance their debts—only this time, the packages would be much larger. If these countries needed trillions of dollars to settle their debts, the pressure on credit markets might send long-term interest rates higher around the world.
Though the D-7 countries have been able to sustain their debts so far, the markets have been sending some ominous signals. A huge amount of money has lately been shifting away from government bonds and into corporate securities. Now, Japanese bonds are close to their highest yields since the late 2000s. The rest of the D-7 is posting its highest yields for more than a decade, but the debt levels of the 2010s were more manageable.
In the United States, yields on 30-year Treasury bonds are nearing 5 percent, despite—or perhaps causing—the department’s shift to a shorter-term financing strategy. As its options narrow, the Treasury is rolling over its borrowing more frequently to avoid paying rising rates on long-term debt. More worrisome, it is increasingly relying on primary dealers (mainly big banks) to refinance its debts, implying that other investors have less appetite for its securities.
Indeed, since debt levels began to scrape all-time highs and inflation rates started to chip away at the value of currencies, investors have been looking for safe havens outside of the major markets. Faced with a chain of devaluations, they would essentially be playing a financial game of musical chairs. With currencies declining all around them, the goal would be to put their money in the last assets that maintained their value.
Among the traditional favorites, gold stands out. Since the U.S. Federal Reserve’s tightening campaign kicked off in 2022, its price in dollars has risen 70 percent. Meanwhile, the Swiss franc has risen 17 percent against the dollar and 7 percent against the euro. Bitcoin, though much more volatile, has almost tripled in value. And some investors still see euro-denominated securities as a safe haven, likely assuming Germany will be the backstop.
For now, the markets are relatively quiet. But the IMF expects the pressure on government budgets to grow as tariffs restrain global growth, and economic experts in the D-7 continue to warn of fiscal crises. Without the realistic prospect of reducing their debts via higher taxes or lower spending, D-7 countries are still on the path to devaluation. Will they try to manage it themselves or wait until the markets force their hands?