In the wake of the COVID-19 pandemic, governments in emerging market economies (EMEs) ratcheted up their spending and borrowing, leading to the sharp increases in debt shown in Figure 1 below. This rise in debt poses concerns that these economies may be headed for default and crisis. However, the decline in interest rates since the pandemic began should make it easier to service their debt. Therefore, aside from several economies with weak positions — especially Brazil and South Africa — serious fiscal problems do not appear imminent.
Figure 1: Median EME Sovereign Debt
Let me start with the well-known relationship used to assess the sustainability of a country’s debt: the change in debt is a function of r minus g (that is, the real interest rate minus the GDP growth rate), the stock of debt, and the primary deficit.
In the second line, the equation is rewritten so as to distinguish between the nominal interest service burden of the debt — (it)*(Debt/GDP) — and the nominal GDP growth rate times the debt — (gt + pt)*(Debt/GDP). The interest service burden may be the most immediate concern for fiscally challenged EMEs — if they cannot make their interest payments, investors will not be willing to wait for nominal GDP growth to shrink the share of debt in the economy. So has the interest service burden risen or fallen since the advent of the pandemic?
Below, I’ve provided a simple example applied to the United States. The 10-year Treasury yield has fallen from 1.6 percent right before the pandemic to only about 1.2 percent at present. That is a very slightly larger decline, in proportional terms, than the projected rise in the US federal debt held by the public — from 79 percent of GDP in 2019 to 102 percent this year. (CBO, The Budget and Economic Outlook: 2021 to 2031, February 2021) In consequence, if all the debt were paying the current 10-year yield, the interest service ratio would edge down to 1.22 percent this year.
To be sure, this calculation cuts many corners: Much of the debt was contracted earlier at rates that won’t automatically adjust down, and, moreover, yields won’t stay low forever. However, the example shows that as it rolls over its debt at lower rates, the US government can substantially offset the effect of higher debt on its interest service burden.
Will emerging market economies also enjoy the benefits of lower interest rates? Figure 2 looks at the dollar interest rates faced by EME governments. Though US Treasury yields have declined since the beginning of the pandemic, the spreads paid by EM governments have risen some. All in all, dollar interest rates faced by EMEs have fallen, but not hugely.
Figure 2: Dollar Interest Rates Faced by EME Governments
Figure 3 compares the change in dollar interest rates for individual countries between January 2020 (along the x-axis) and January 2021 (along the y-axis). Most countries — except the relatively vulnerable Brazil, South Africa, and Turkey — did enjoy substantial declines.
Figure 3: EME Dollar Interest Rates: January 2021 vs. January 2020
However, in addition to dollar debt, some or most of the debt issued by EM governments is in domestic currency. Figure 4 shows that domestic-currency rates also declined in most countries.
Figure 4: EM domestic currency 10-year yields: Jan 2021 vs. Jan 2020
Let’s now turn to the debt side of the ledger. Based on IMF projections, sovereign debt looks to have increased substantially between 2019 and 2021 in all the major EMEs. (Figure 5)
Figure 5: EME Sovereign Debt: 2021 vs. 2020
Figure 6 puts everything together. The x-axis shows the IMF projection for government debt in 2021 as a ratio to its 2020 value; the y-axis shows the ratio of interest rates expected to prevail in 2021 compared to its pre-pandemic interest rate. These interest rates are weighted averages of the dollar and domestic-currency interest rates shown earlier, based on the shares of external and domestic debt in total government debt.
The swooping red line indicates the set of points where the proportional decline in interest rates exactly equals the rise in debt. Countries below that line, such as Poland and Taiwan, could enjoy a decline in interest payments, while countries above that line, such as Brazil and Turkey, experience an increase.
Figure 6: 2021/2020 Interest Rate Ratio vs. 2021/2019 Debt Ratio
Figure 7 calculates the change in interest payment ratio between 2019 and 2021 and plots it against the debt stock — countries with high debt and large increases in interest payments are most at risk: Brazil and South Africa. Turkey is a murkier case: not-so-high debt, but a large rise in interest payments. In the remainder of the countries, the rise in debt service is pretty limited, and actually declines in six countries.
Figure 7: Change in Implicit Interest Service/GDP (2021 vs. 2019) vs. 2020 Debt
Interest Payments/GDP = Weighted Average Interest rate * Debt/GDP
To conclude, the recent rise in EME sovereign debt may pose substantial problems for several countries, especially Brazil and South Africa. But the decline in global interest rates should ease the burden for many other emerging market governments. Therefore, a broad-based emerging markets crisis does not seem the most likely scenario for the coming year. EMEs should continue to take advantage of low rates by refinancing as much of their debt as possible, and perhaps even borrowing more to build up a war chest for more difficult times ahead. Even if increases in EME debt are warranted by current low rates and ready funding availability at present, this could turn on a dime, and then the higher debts would represent a significant source of risk.
This article was first published by the American Enterprise Institute.