US fiscal deficit threat to global financial stability

The United States is grappling with an unsustainable fiscal path that threatens global financial stability. With massive budget deficits persisting and Treasury debt rapidly climbing, the risks of higher borrowing costs, refinancing pressures, and disruptive spillovers to currencies, commodities and capital flows are mounting. Emerging markets and developing economies are especially vulnerable.

The country's mounting fiscal burden is starkly evident in the fiscal year 2025 federal budget deficit of $1.8 trillion, which is equivalent to about 5.9 percent of the country's GDP. Gross federal debt now exceeds $38 trillion, with debt held by the public nearly 100 percent of the GDP at the end of fiscal year 2025. Ongoing large-scale Treasury issuance and a relatively short average debt maturity amplify refinancing risks and push up interest costs.

Net interest payments on the public debt now surpass $1 trillion annually. Treasury yields have eased from mid-2025 highs. The 10-year bond yield hovered around 4.24 percent and the 30-year one near 4.85 percent in late January. The Congressional Budget Office projects debt held by the public will climb to 118 percent of the GDP by 2035, with interest consuming an ever-larger share of federal revenues. Research shows that a 1 percentage point increase in the debt-to-GDP ratio tends to push long-term interest rates higher by roughly 2 to 3 basis points, creating a self-reinforcing cycle of rising borrowing costs and ballooning interest payments.

Recent data also point to a diminishing foreign appetite for US debt. Foreign investors hold approximately 30 percent of US public debt, or about 24 percent of total gross federal debt. This share has edged down modestly as domestic holders — including the Federal Reserve, mutual funds, and pension funds — have expanded faster than foreign demand. Japan remains the largest foreign holder, with more than $1.2 trillion as of November 2025.

Political winds at the Fed are shifting in ways that heighten fiscal-monetary tensions. On Jan 30, US President Donald Trump nominated former Fed governor Kevin Warsh to succeed Jerome Powell as Federal Reserve Chair. Trump has pressed aggressively for lower interest rates to alleviate government borrowing costs amid the high deficits. Warsh, long regarded as an inflation hawk, has recently signaled greater openness to accommodation, citing productivity gains as providing policy room.

This dynamic raises legitimate concerns about fiscal dominance, where debt-servicing imperatives constrain monetary policy. Aggressive rate cuts or balance-sheet expansion could be perceived as monetizing deficits, eroding Fed independence. Markets might respond with a weaker dollar, reduced real yields, or doubts about safe-haven role — potentially triggering capital outflows from the US in search of higher returns elsewhere.

Global spillover effects are already emerging from these dynamics. A weaker dollar could narrow the US trade deficit but also spark capital outflows from the US. Recipient economies may see their currencies appreciate, undermining export competitiveness, inflating asset prices, fueling import-driven inflation, and heightening vulnerability to sudden reversals. Commodity volatility — exacerbated by tariffs, geopolitics, and dollar fluctuations — further strains both importers via higher inflation and exporters via instability. Softening foreign demand and shifts toward gold already question the dollar's entrenched dominance. Without US reforms, the risks include capital flow volatility, currency and inflation swings, debt distress and eroded monetary policy autonomy for emerging markets, potentially culminating in stagflation or global contagion.

The US should prioritize fiscal reforms, including extending debt maturities to reduce rollover risks, curbing structural deficits, and stabilizing yields to ease global rate pressures. Critically, preserving the Fed's independence is essential to avoid perceptions of monetization, dollar depreciation, and destabilizing capital flow swings. It is essential to address the underlying imbalances through spending discipline and revenue measures.

Emerging economies can mitigate risks from currency appreciation and volatile capital flows with targeted measures. Macroprudential tools, such as higher bank reserve requirements, loan-to-value or debt-service-to-income caps, and restrictions on foreign-currency lending, can prevent credit booms and excessive leverage. Capital flow management, used judiciously, may include taxes on short-term inflows, quantitative limits on portfolio investments or minimum holding periods. Stronger banking supervision, ample foreign-exchange reserves and tighter rules on external exposures of banks are critical, as are efforts to diversify funding sources, promote local-currency bond issuance and reinforce regional financial safety nets or swap arrangements. These policies and sound domestic fundamentals together offer emerging markets a stronger buffer against external volatility.

Broader global cooperation remains critical as well. Multilateral institutions such as the IMF and G20 should facilitate debt restructuring, enhance safety nets and promote policy coordination. Innovations such as blockchain-enabled cross-border payments and greater internationalization of the yuan could gradually lessen dollar dependence, but these must be embedded within strong regulatory frameworks and international standards.

The author is a professor at the National School of Development in Peking University and the deputy director of the China Center for Economic Research there.

The views do not necessarily represent those of China Daily.

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