January 30, 2023
When interest rates rise, the risk of default increases
Governments, companies, and households face a very high interest burden
Their solvency becomes a major issue
Nevertheless, investors are still wondering if this danger is real

CHART OF THE WEEK: "Share of zombie companies in the world"


Over the past 40 years, global public and private debt have doubled. From 120% of Gross Domestic Product (GDP) in 1981, it now stands at 250% (see Fig. 2). The slight decline in 2021 should not be seen as overly optimistic, as it only compensates for one third of the surge in 2020 during the covid pandemic. It is also interesting to note that developed economies have a total debt ratio of 292%, compared to "only" 130% for emerging markets excluding China. This surge in debt will have been made possible by structurally lower interest rates. The environment is changing: interest rates have risen widely and rapidly in 2022, not experienced since the late 1970s (see Fig. 3).

Anyone who sees interest rates rising so fast is concerned about paying off their debt, especially if it is large. This is one of the founding rules of economics. Just as the balance between supply and demand makes it possible to determine prices, the relationship between interest rates and debt makes it possible to assess solvency. Humans experimented with lending in these exchanges very early on, even before they abandoned barter for monetary trade. For each loan (a risk) there is a return (a benefit), which is linked to the preference for the present and the possibility of default (non-repayment at maturity). Yield and risk are thus two sides of the same coin. They are related to the reliability of the debtor, his future income, his total debt level, but also the cost of this debt. All other things being equal, creditors instinctively understand that if interest rates rise, the risk of their debtor defaulting increases exponentially.

In 2023, investors seem to be willing to question the fundamental basis of financial theory. From the scenarios anticipated by the major investment banks, borrowers' ability to repay does not seem to be an issue. None of them mention this subject. However, the data sends a warning message: solvency risk and by extension liquidity risk (see Fig. 4) has never been so high, whether for governments, companies, or households.

This time, investors are not faced with a black swan but a gray rhino. The black swan, popularised by Nassim Taleb in 2007, refers to an extreme event with a very high cost but very low probability. The gray rhino, mentioned by Michele Wucker in 2016, also refers to a high-impact threat, this time obvious but ignored or minimized. The gray rhino is not a surprise. It swoops in on investors after a series of warnings whose consequences were too small to really worry him. On the contrary, they have ended up reassuring him about his ability to face the real danger they are exposed to.


Governments run budget deficits for many reasons. In most developed countries, the imbalance between expenditures and revenues (primary balance deficit) is so recurrent that it seems to have become the norm. And the interest paid on past debt is an increasing burden (see Fig. 5).

Over the years, deficits have accumulated. They ended up generating an extraordinary public debt (see Fig. 6). While academic studies stipulate that public debt should not exceed 60% of GDP to be sustainable and 90% to avoid default, the ratios posted by the main countries are higher. China is at 84%, Eurozone countries average 92%, the United States at 123% and Japan at 261%.

As with the gray rhino, investors are finding tangible reasons to be reassured. In the case of China, its economic growth is so strong that its debt-to-GDP ratio could soon fall. On the Old Continent, good performers such as Germany, the Netherlands and now Ireland are managing to make up for bad performers such as Greece and Italy. For their part, the United States cannot worry as they are the world's leading economic, political, military, and financial power. The dollar has a special status that will always draw capital flows. As for Japan, its public debt is certainly not redeemable but foreign investors pay little attention to it since more than 90% of it is held by the Japanese themselves: households, non-financial companies and now the central bank, which has absorbed three quarters of new Japanese sovereign bond issues in 2022.

Bond investors' optimism may eventually fade. In the US, for example, the debt ceiling has just been reached and there will be intense negotiations between Republicans and Democrats before Congress finally lifts it. This important issue is nothing compared to the debt sustainability. Interest charges have never been a concern until now because rates were falling faster than debt was growing. Now that interest rates have rebounded, interest charges will become a greater burden (see Fig. 7).

This phenomenon is likely to bite even harder as the US will have to roll over 40% of its sovereign bonds in the next two years, compared to 24% for the Eurozone (see Fig. 8). The Treasury currently pays an average coupon of 1.6% on its bond liabilities. New loans will have rates between 3.5% and 4.7%, i.e. two to three times higher. If nothing is done, interest charges will soon represent 5% of GDP, i.e. 15% of government expenditures compared with 3% recently.


The evolution of corporate debt is a growing concern. Some companies are not making enough profit to pay the interests on their debt, let alone pay back the capital. They are commonly known as "zombie" companies. While they are doomed to fail, they manage to keep themselves "alive" by granting loans at very low rates. There are several methods for identifying zombie companies. The enhanced, more scrupulous version, among other things, includes only mature companies that are at least three years old, not including start-ups that are not yet making earnings.

The number of zombie companies increased significantly between 1990 and 2020 (see Chart of the Week), from just under 1.5% in 1990 to a transitional high of 6.8% in 2003. This percentage then halved between 2003 and 2007, before rebounding to over 7% recently.

In the coming years, zombie companies will face three major challenges.

  • First, high interest rates will increase financing costs as soon as these companies have to issue new debt. Admittedly, many of them have taken advantage of the last few years to extend their maturities and not be confronted with the problem of debt rollover too quickly, but the hourglass is running out.
  • Second, lending to zombie companies is now less attractive to banks and credit investors, as they can again benefit from relatively high rates by lending to good quality companies.
  • Third, by fighting inflation, central banks are dampening aggregate demand, which means less income for companies and therefore less cash to pay off their debts.

In this context, the number of zombie companies will increase while their ability to stay alive will decrease. The rate of corporate bankruptcies is expected to rise in the next few years. In the US, the average annual default rate for high yield bonds is around 4% per year. However, in times of stress, this default rate soars, as was the case during the Great Financial Crisis when it peaked at 15% (see Fig.9).

While in the equity market, defensive sectors (consumer staples, healthcare, and utilities) are more resilient in an economic downturn, this is not necessarily the case in the bond market. Paradoxically, these sectors account for a large share of the zombie companies (see Fig. 10) and they have experienced several credit downgrades in 2022, notably healthcare.


Household debt has also reached record levels. In the US, it has reached USD 58,000 per adult (see Fig. 11), more than at the previous peak in 2008. It represents 89% of household disposable income (see Fig. 12).

This ratio may seem satisfying, as it is well below the one prevailing before the subprime crisis in 2008, when it stood at 115%. However, when adjusted for inflation, in real terms, household debt looks much less sustainable. While Americans have seen their incomes grow over the past 15 years, the increase in the volume of credit in the first instance and the sharp decline in purchasing power in the second have undermined their ability to service their debts.

In the coming months, if wages do not rise faster than inflation and mortgage rates, the situation could become challenging. In concrete terms, this means that incomes may not be strong enough to allow households to simultaneously afford food, health care mortgage payments.

With more than two-thirds of Americans' debt tied to their homes, changes in mortgage rates have a major impact. In two years, the monthly payments of Americans with 30-year mortgages have risen from USD 1,600 to USD 2,600 (see Fig. 13). For some, the burden is becoming too heavy. To make ends meet, they have no choice but to add other credits.

Looking at the increasing evolution of consumer credit, be it through credit cards, revolving or buy now pay later offers, it seems that the outlines of the crisis are already visible. Not only are volumes increasing, but so are interest rates (see Fig. 14) or penalties for late payment. According to the Consumer Financial Protection Bureau, the use of buy now pay later to pay for essentials such as food, gasoline, or utilities has risen sharply. The agency also warns that more than 10% of subscribers have had to pay at least one late payment penalty.

In a survey conducted at the end of October 2022, 7 out of 10 Americans responded that they have financial concerns for the next twelve months. Their first concern (31%) is that they will have to take on more debt to meet their needs, with 19% already having done so in 2022. The second is that they will have to pay higher interest on their debts (27%). Households, some of whom are also investors, have therefore spotted the gray rhino.


The problem of excessive debt is global. It concerns most countries but also all economic players: governments, companies, and households. Over the last three years, with the increase in debt and especially with the rise in interest rates, the risk of insolvency has increased. However, the prospect of a debt crisis is so old and recurrent that investors have become used to it. Even worse, they believe they will be able to deal with it easily: since everything has gone well so far, is there really any risk in facing a gray rhino? The answer is yes.