Debt-Interest Spiral

A debt-interest spiral is a self-reinforcing process in which a government borrows to meet interest payments, thereby enlarging its debt and future interest obligations. It becomes a serious sustainability problem when debt and interest grow persistently faster than government income or nominal GDP, requiring ever more borrowing merely to service past debt.

How the spiral develops

The process begins when current revenue is insufficient to cover non-interest expenditure and interest obligations. If the resulting financing gap is met through fresh borrowing, the unpaid interest is effectively added to the principal.

• A larger debt stock produces a larger interest bill in the next budget, even if the interest rate remains unchanged.
• Repeated borrowing for interest raises the fiscal deficit, while the fiscal deficit excluding interest payments is the primary deficit.
• The cycle intensifies if lenders demand higher interest rates because they perceive greater fiscal or refinancing risk.
• A rising interest burden reduces resources available for development expenditure and essential public services.

Debt dynamics and sustainability

Debt sustainability depends mainly on the effective interest rate, economic growth and the primary balance. In simplified terms, the debt-to-GDP ratio tends to rise when the interest rate exceeds nominal GDP growth and the government continues to run a primary deficit.

• If nominal GDP grows faster than debt, the debt-to-GDP ratio may remain stable or decline despite some borrowing.
• Therefore, borrowing to pay interest does not automatically create an explosive spiral; the crucial issue is whether revenues and GDP can keep pace with debt servicing.
• Persistent adverse debt dynamics can cause crowding out, as a growing share of government resources is committed to interest payments.

Breaking the feedback loop

The spiral can be contained by improving the primary balance while protecting productive expenditure and economic growth.

• Governments can mobilise durable revenue and rationalise low-priority expenditure.
• Better debt management can reduce refinancing risk and the average cost of borrowing.
• Credible medium-term fiscal consolidation can prevent rising debt from generating a higher risk premium.

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