Low interest rates have reduced the pandemic’s damage to emerging market sovereign debt burdens

This post summarizes my presentation for the AEI event, “Coping with COVID-19 in Emerging Market Economies,” on February 5, 2021.[1]

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.[2]

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.


[1]  I would like to thank John Kearns for
excellent research assistance, Jasper Hoek for insightful comments, and Ben
Smith for updated data.

[2] See the very informative article by Jason Furman and Lawrence Summers, “A Reconsideration of Fiscal Policy in the Era of Low Interest Rates,” November 30, 2020.

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