National debt could lead to higher interest rates

(The Edge) – Lee Heng Guie, an economist and executive director at the Socio-Economic Research Centre (SERC), says the national debt could lead to higher interest rates and cause a snowball effect thereafter. “The more investors fear a default on the government’s debt obligations, the more they will sell bonds. This will push bond yields higher and make the debt securities more appealing to investors, relative to stocks,” he adds.

“Yields will then rise, resulting in higher new borrowing costs for investors. If inflation rises, it will lead to higher bond yields as investors demand higher interest rates to protect against the falling value of nominal bonds.”

Professor Yeah Kim Leng, professor of economics at Sunway University Business School, agrees. He says bond yields will see upward pressure as investors demand greater compensation for what they perceive to be an increased risk premium for holding on to government debt securities.

“The selling pressure signals an increase in the risk premium for holding Malaysian government securities (MGS).

But in the unlikely event that the local market lacked the liquidity to pick up bonds offloaded by foreign investors, a painful sequence of events could unfold. “This would become an issue of whether the country is facing a credit crunch, which is to say we no longer have enough money to support bond buying. The government itself would need to step in to buy bonds and other non-performing debt securities [to provide the much-needed liquidity],” Yeah explains.

The worst-case scenario would be if the bond sell-offs become so deep that Bank Negara Malaysia is forced to print more money. But this would present yet another problem. With the runaway bond yields forcing the central bank to increase the amount of currency in circulation, an obvious consequence would be inflation. As the ringgit loses its value, the price of goods and services would begin to rise.

One of the tools the central bank has at its disposal to keep inflation in check would be to raise the overnight policy rate (OPR). This, in turn, would prompt banks to raise interest rates across the board. “The rising interest rates would act to strengthen the value of the ringgit and hopefully, attract capital inflows now that the yields of Malaysian government debt securities have increased,” says Yeah.

On the other hand, rising interest rates would dampen demand, he adds. With slowing demand, there would be weaker credit flows and overall economic activity would grind to a halt. This is where the country would enter the dreaded “austerity period”.

“As a result, the demand for real estate would be adversely affected. Obviously, property values respond negatively to rising interest rates as there would be less credit available for borrowing to purchase real estate,” says Yeah.