The drafting of the 2026 national budget was accompanied, more loudly than in other years, by discussions about the growing budget deficit, which is expected to remain high in the coming years as well (the Ministry of Finance forecasts a budget deficit of 3% of gross domestic product (GDP) in 2026, 4.1% of GDP in 2027 and closer to 4% of GDP in subsequent years too). Consequently, the level of public debt will also continue to rise: whereas before the Covid-19 crisis Latvia's general government debt level fluctuated at around 40% of GDP, that level now already exceeds 45% of GDP, and forecasts for the coming years point to more than 5%, while pessimistic scenarios suggest as much as 60% of GDP [1]. Do such trends give cause for concern about the sustainability of government debt?

This is not a question with a clear-cut answer. Debt sustainability is determined by many different factors, both objective and subjective. On the one hand, Latvia's debt level is the highest among the Baltic states, even though the main challenges relating to government budget expenditure — security, demography, education — are similar. On the other hand, compared with other European Union (EU) countries Latvia's debt is still relatively low: the EU average debt level currently exceeds 80% of GDP slightly, and even in Germany, long the benchmark of European fiscal discipline, the debt level now exceeds 60% of GDP.

Is there some critical level of debt beyond which its dynamics become uncontrollable and the debt itself therefore unsustainable? There is no single "magic" number. Belgium, for example, is able to sustain a debt level above 100% of GDP over a long period, whereas countries such as Italy and France encounter difficulties in managing their debt at a similar level, because as doubts about debt sustainability grow, borrowing interest rates begin to rise, making the debt even harder to control.

Debt sustainability depends to a large extent on economic growth: if growth is strong, higher debt is easier to manage; if growth is weak, even lower debt can create problems. The direction of fiscal policy also matters — reducing the deficit and putting debt on a downward path is often more favourable for sustainability overall than a comparatively low level of debt that is rising rapidly. The influence of general market sentiment is likewise significant: when rates are low, high debt may appear acceptable and easy to service, but the assessment of debt sustainability can change dramatically if borrowing rates rise (for instance, as a result of a change in the central bank's monetary policy).

So, when thinking about debt sustainability, there is little point in focusing on one particular number. The risks need to be analysed, even if we do not know exactly when they might materialise. The higher the debt, the more vulnerable the country is to external shocks. Every shock that would be easily absorbed at a low level of debt can, at a high level of debt, have a non-linear and disproportionately large economic impact.

To illustrate these risks around debt sustainability more clearly, we have developed a public debt sustainability calculator [2]. It does not tell you precisely when debt becomes unsustainable, but it helps you understand the main principles governing debt dynamics and the factors that influence them.

The analysis is based on a baseline scenario for Latvia's economic development, calibrated using Latvia's historical data and long-term forecasts. If everything unfolds in line with this scenario and no external circumstances change, debt should decline over the long term and converge towards a stable level relative to GDP.

However, experience shows that a scenario in which Latvia's economy remains stable and unchanged over the coming decades is highly unlikely. As before, the economy will continue to be affected by various unforeseen events, or shocks, while fiscal needs, priorities and fiscal policy itself will in all likelihood continue to change. Monetary policy, too, will continue to respond to changes in the economic environment in Europe, and this will also affect borrowing rates and debt dynamics in Latvia.

The calculator makes it possible to model various shocks — both positive and negative — and their duration. The longer the shock, the greater its impact on debt dynamics. Shocks can also be combined: for example, you can model a rise in inflation specific to Latvia (say, as a result of wage growth) to which the European Central Bank (ECB) does not respond and does not raise interest rates, or a rise in inflation across Europe to which the ECB does respond by raising interest rates. You can likewise model an increase in the budget deficit, which may accelerate economic growth in the short term but in the medium term leads to higher debt and higher interest rates, which reduce economic growth and create additional risks to debt sustainability. If a confidence shock is added on top of that — an increase in risk premia — we can observe self-fulfilling dynamics: debt that seemed sustainable while investor confidence was high does indeed become unsustainable once investors begin to doubt its sustainability.

This shows how difficult it is to determine debt sustainability in advance. It depends on:

# objective circumstances that policymakers can influence (fiscal policy, for example),

# macroeconomic shocks that cannot be forecast in advance, but whose economic impact can be modelled once they have occurred,

# shifts in market sentiment, which cannot be forecast in advance and whose impact is hard to quantify even after they have taken place.

Yet despite the non-linearity and unpredictability, some economic regularities hold under all circumstances. The lower the level of debt, the smaller the risk that debt dynamics will become uncontrollable in the event of a negative shock. And any level of debt is easier to sustain if the economy is growing and developing steadily and robustly. So if we do borrow, let it be with the specific aim of improving long-term growth potential.

We hope this tool will prove useful to students and policymakers alike, helping them better understand the risks and reduce unpleasant surprises in the future.

[1] Informative report by the Ministry of Finance, "On the forecasts of macroeconomic indicators, revenue and the general government budget balance for 2026, 2027, 2028 and 2029" https://tapportals.mk.gov.lv/legal_acts/1b22acf1-7d8a-413f-95b0-5e23c60029bc#

[2] We would also like to thank Krišjānis Tamužs, who took part in developing the calculator during his internship at Latvijas Banka.