October

Emerging Markets Economies Debt Is Growing... What to expect?

By Adelphe Ekponon, CERF Research Associate

After the 2008 financial crisis, Central banks have implemented accommodative monetary policies with the objective to revitalize countries economic activities. As a consequence, many countries have increased their borrowing in dollar and euro-denominated debt, leading to an increase of debt/GDP ratio around the world. As an example, this ratio was on average about 82% in Europe by the end of 2017 compared to 60% before the crisis, according to Eurostat.

The prime concern, however, is currently on the Emerging Markets Economies (EMEs) side, at least for two reasons.

First, many Emerging countries have increased their exposure to foreign debt (especially to hard currencies like dollar or euro). Their overall government debt as percentage of GDP went from 41 to 51 from 2008 to 2017 (BIS Quarterly Review, September 2017). In the same period, the government debt of EMEs doubled to reached $11.7 trillion with foreign currency debt also rising. Yet the problem with foreign-currency debt is that the government cannot inflate them away and difficulties to service them may be transmitted to the local currency debt market.

Second, the US Federal Reserve and the European central Bank are ending their accommodative monetary policies, which implies that interests rate will now be on the rise and that EMEs borrowing costs as well. From past experiences, interest rate rise in the US particularly has shown to be a trigger of many emerging countries debt crisis. Before EMEs debt crisis, such as Latin America in 1980, Mexico in 1994 and Asia in 1997, interests rate in the US were growing after remaining low.

Other factors may even worsen the situation, i.e. contagion or capital outflow, among others.  

In their paper “Macroeconomic Risk, Investor Preferences, and Sovereign Credit Spreads”, CCFin research associate Adelphe Ekponon and his co-authors explore the mechanism through which macroeconomic conditions combined with global investors aversion drive countries borrowing costs. According to this study, the link between economic conditions in the US and sovereign debt yields originate from the existence of a global business cycle, as countries tend on average, to be in good or bad time around the same periods. They found that this global business cycle increases the risk of defaulting, but also the government’s unwillingness to repay. The other mechanism is that investors’ higher risk aversion amplifies these effects. In this case, risky assets sell-offs are more pronounced in recession leading to a lower risk-free rate on average, to which the government optimally respond by issuing more debt.

It is likely that countries are going to discipline themselves in the coming months or years as borrowing costs surge… if there is no sudden switch to a global economic downturn.