The World Tied $3.5 Trillion-Plus of Debt to Inflation. The Costs Are Now Adding Up. | Kanebridge News
Share Button

The World Tied $3.5 Trillion-Plus of Debt to Inflation. The Costs Are Now Adding Up.

With roughly $770 billion of borrowings linked to retail prices, Britain is feeling the pinch

By CHELSEY DULANEY
Wed, Jul 26, 2023 8:32amGrey Clock 5 min

Governments and companies around the world spent decades loading up on trillions of dollars of debt whose interest costs rise and fall alongside inflation. But what served as cheap funding when prices were stagnant has rapidly become more expensive.

The inflation-linked headache echoes the broader challenges arising at the end of more than a decade of global easy money, in which debtors borrowed vast amounts at very low, and sometimes negative, interest rates. Investors are on alert for financial vulnerabilities after a crisis in U.S. regional banks this year, and with strains emerging in commercial property.

Borrowing costs of all sorts have risen sharply for governments, businesses and consumers, as central banks have raised key interest rates to combat price pressures. Rates have surged on inflation-linked borrowings, but these aren’t the only source of pain.

As standard bonds with fixed rates mature, they need to be replaced with more expensive new debt. Meanwhile, interest rates on loans are often floating, meaning they quickly reflect changes in policy rates.

Yields on benchmark 10-year fixed-rate bonds, a proxy for government borrowing costs, have climbed to about 4.3% for the U.K. and 3.9% for the U.S. Both were below 1% during the pandemic.

Governments will pay roughly $2.2 trillion in overall debt interest this year, Fitch Ratings estimates. The U.S. Treasury’s interest cost grew 25% to $652 billion in the nine months through June. Germany’s debt-servicing bill is expected to soar to 30 billion euros this year, or some $33.2 billion, from €4 billion in 2021.

Governments had $3.5 trillion in outstanding inflation-linked debt at the end of 2022, according to the Bank for International Settlements, equivalent to about 11% of their total borrowings.

The poster child for the inflation-linked problem is Britain, which has experienced the fastest rise in debt costs in the Group of Seven advanced democracies. The U.K. first embraced such debt under Prime Minister Margaret Thatcher and in 1981 became one of the first developed economies to issue inflation-linked debt: securities that are known as linkers there and Treasury Inflation-Protected Securities, or TIPS, in the U.S. Both the amount due to investors once the bonds mature and the regular interest payments they receive move with inflation.

About a quarter of U.K. debt is now tied to inflation, trailing only a handful of emerging markets with a history of runaway prices such as Uruguay, Brazil and Chile.

“We stick out like a sore thumb,” said Sanjay Raja, chief U.K. economist at Deutsche Bank.

The U.K.’s debt woes are complicated by its longstanding reliance on a measure of price increases that has fallen out of favour: the retail price index, or RPI. Some 600 billion pounds, equivalent to roughly $770 billion, of bonds are linked to this gauge, which has consistently risen faster than more widely used consumer-price indexes. London has pledged to phase out RPI by 2030.

Inflation as measured by the RPI topped 14% in October and was still 11% in June compared with a year earlier. Economists expect U.K. inflation to keep falling this year, albeit more slowly than in other major economies.

In theory, higher interest payouts should be balanced by rising revenue. While higher inflation means bigger payouts to bondholders, it should also bring in more taxes.

That logic holds especially true in markets like the U.K., where inflation gauges are deeply embedded in the economy. Tax thresholds, pension and welfare payments, rail fares and cellphone bills are often linked to price indexes.

But the energy shock that fuelled recent inflation upended that math, since higher energy bills drove up RPI even as earnings and consumer spending lagged behind. The U.K. is experiencing the “wrong sort of inflation,” the U.K.’s Office for Budget Responsibility said this month. The sensitivity of U.K. debt to inflation was unprecedented, the watchdog said.

The U.K.’s debt sustainability is a focus for investors after a market meltdown last fall, triggered by then-Prime Minister Liz Truss’s tax-cutting plans.

Her successor Rishi Sunak and his Chancellor Jeremy Hunt have sought to restore market confidence with pledges to contain inflation and bring down debt. As the U.K.’s interest costs climb, and with debt now surpassing 100% of gross domestic product, those promises are getting harder to keep while maintaining investor confidence.

The debt burden also undermines Sunak’s hopes to woo voters and revive the economy with tax cuts and spending measures ahead of a general election expected to take place next year.

“We could quickly be in a situation where we’re facing some renewed sense of crisis, particularly with an economic backdrop of stagflation with really weak growth and overshooting inflation,” said Mark Dowding, chief investment officer at RBC BlueBay Asset Management in London. “Further policy missteps could easily be punished by the market.”

Higher bond yields and stickier inflation will add an extra £30 billion to the U.K.’s annual government debt bill, estimates Bank of America economist Robert Wood.

“The government has three options: You can plan for weaker spending, you could raise taxes or you could borrow more,” he said. “Certainly one could say that this rise in debt-interest costs is incompatible with cutting taxes.”

The U.K. is selling fewer linkers, which are likely to make up 11% of bond issuance this fiscal year, down from above 20% throughout the 2010s.

One veteran U.K. central banker said linkers had largely done their job as envisioned in the 1980s.

“We were coming out of a decade in which inflation had been extremely high. People were very skeptical about the ability of any government, particularly the Conservative government, to bring inflation down to a low and stable rate,” said Charles Goodhart, who was an adviser at the Bank of England between 1969 and 1985.

Fears that linkers would lead to fresh wage-price spirals as unions demanded inflation-linked increases, didn’t play out, he said. Thatcher, who called inflation “the destroyer of all,” saw linkers as “sleeping policemen,” ensuring the government wasn’t tempted to let inflation run to help inflate debt away.

“It makes the current fiscal position more difficult. But that’s what Mrs. Thatcher actually wanted,” said Goodhart. “She wanted governments to resist inflation more strongly.”

Companies are also feeling the pressure from inflation-linked borrowing. The U.K.’s largest water company, Thames Water, nearly collapsed in recent weeks as investors questioned its ability to repay £14 billion in debt, about half of which is linked to inflation. Thames Water’s debt is RPI-linked, but customer prices now track CPI, which lags behind the RPI by about 3 percentage points more slowly.



MOST POPULAR

Chris Dixon, a partner who led the charge, says he has a ‘very long-term horizon’

Americans now think they need at least $1.25 million for retirement, a 20% increase from a year ago, according to a survey by Northwestern Mutual

Related Stories
Money
Preparatory Work for UAE to Oman Hafeet Rail Project Commences at Full Speed
Money
BCG report ranks UAE’s Etisalat as fourth top value creator in global telecoms.
Money
USD 9.25 Million in Investments Committed to Start-ups during FinTech World Cup at Dubai FinTech Summit
Preparatory Work for UAE to Oman Hafeet Rail Project Commences at Full Speed

Preparations have begun on the transformative UAE to Oman Hafeet Rail network, revealing significant construction details during a site visit.

Thu, May 16, 2024 3 min

The $3bn Hafeet Rail project between the UAE and Oman will feature 60 bridges and a 2.5km tunnel, making it an “architectural and engineering marvel,” according to CEO Ahmed Al Musawa Al Hashemi.

Hafeet Rail has announced that preparatory work is moving full speed ahead for constructing the transformative railway link between the UAE and Oman. This announcement was made during a site visit attended by key officials, members of the Asyad and Hafeet Rail executive management teams, project contractors, and consultants.

Key Highlights

During the visit, attendees were introduced to the main components of the project, including passenger, repair, and shipping stations, as well as major bridges and tunnel sites.

The Hafeet Rail project is set to play a very important role in enhancing local and regional trade, unlocking new opportunities in the infrastructure, transportation, and logistics sectors, and fostering economic diversification. It will also strengthen bilateral relations between the UAE and Oman.

The project will involve constructing 60 bridges, some reaching heights of up to 34 meters, and tunnels extending 2.5 kilometres. The Hafeet Rail team showcased the latest rail technologies and innovative engineering and architectural solutions designed to navigate the challenging geographical terrain and weather conditions while maintaining high standards of efficiency and safety.

The rail network will boost various industrial sectors and economic activities and significantly impact the tourism industry by facilitating easier and faster travel between the two countries.

Ahmed Al Bulushi, Asyad Group Chief Executive Asset, noted that the project’s rapid progress reflects the commitment of the UAE and Oman to developing and realizing the project’s multifaceted benefits.

Investment and Future Impact

Al Bulushi added that investments in developing local capabilities and expertise in rail-related disciplines over recent years have enabled the project to reach the implementation phase successfully under the leadership of highly efficient and professional national talent.

Hafeet Rail’s CEO Ahmed Al Musawa Al Hashemi emphasized, “The commencement of preparatory works for construction is a testament to the robust synergy between all parties involved in both nations, achieving this milestone in record time. We are confidently laying down the right tracks thanks to the shareholders of Hafeet Rail and the expertise of local companies in Oman and the UAE, alongside international partners.”

During the site visit, the visitors explored some of the key preparatory sites, including Wadi Al Jizi, where a 700-meter-long bridge towering 34 meters will be constructed. This ambitious project is envisioned as an architectural and engineering marvel in a complex geographical landscape.

Future phases will require more collaboration, with a continued focus on quality, safety, and environmental considerations in line with the international industry best practices.

The Hafeet Rail project represents the first-of-its-kind railway network linking two Gulf nations, marking a significant shift in regional goods transportation. This efficient and reliable transportation option will reduce dependence on slower and less sustainable road transport.

Hafeet Rail promises a 40% reduction in shipping costs and a 50% in transit times compared to traditional land transportation methods, as it will be connecting five major ports and several industrial and free zones in both countries.

This shift will reduce reliance on road transport by cars and trucks and promote more sustainable shipping practices. The establishment of the railway network will also create significant opportunities for SMEs in construction, engineering, and logistics support, acting as a catalyst for economic growth and innovation within the domestic economy.

By linking major ports, the Hafeet Rail project will enable local SMEs to import, export, and distribute their products more effectively, enhancing their market reach and global competitiveness.

MOST POPULAR

Chris Dixon, a partner who led the charge, says he has a ‘very long-term horizon’

Americans now think they need at least $1.25 million for retirement, a 20% increase from a year ago, according to a survey by Northwestern Mutual

0
    Your Cart
    Your cart is emptyReturn to Shop