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Emerging sovereign debt: interpretation of recent trends

THE ESSENTIAL

 

Whereas some countries such as Turkey or the Philippines have succeeded in controlling and even reducing their debt ratio over the recent period, the debt of other emerging countries such as Brazil and South Africa has accelerated over the last few years. Here, we highlight the factors which, since 2010, have driven the debt ratio of five countries differing in their economic environment and budgetary objectives.

The recent dynamics of these debt ratios clearly appear to be the reflection of the economic situation within each country, but also the ability of these countries to implement an effective fiscal policy and control exchange rate fluctuations via a resolute monetary policy.

Therefore, among the five countries studied, controlling the debt ratio represents a particularly important challenge for Brazil and South Africa. Both these countries, whose debt dynamics appear worrying, are characterised by deteriorated economic activity and public finances and have seen their interest rate environment affected, on the one hand by the chaotic political situation, and on the other hand by the sluggish economy and the need to provide convincing evidence of the credibility of fiscal policy.

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PUBLICATION

 

Emerging countries have not necessarily stood out through a significant increase in their public debt ratios in the 2000s. That said, over the last few years, some of them have seen a worrying rise in their debt ratio. This is true for South Africa in particular, but also Russia, whereas other countries have embarked on a much healthier trajectory (Turkey or the Philippines for example). Here, we intend to examine the factors that have contributed to the public debt dynamics of five countries with varied economic environments, presenting more or less credible budgetary objectives and with different exchange rate risk exposure (see graph 1).1

Health of the public finances: reflection of the quality of the institutions and the economic environment

Even more so than among developed countries, the accumulation over time of sovereign debt is the result of both the quality of the institutions and the underlying economic environment among emerging countries.

The trend in the debt ratio is obviously a reflection of the fiscal policy conducted by the countries via the structural component of the primary balance, which corresponds to the discretionary budgetary measures implemented by the country over time. However, even more so than among developed country peers, emerging countries are characterised by the less well-established credibility of fiscal policies, and the continuation of economic policies that may prove to be less important, especially for countries in a political and institutional transition phase. These characteristics result in higher risk premiums (reflected in the interest rates at which investors – particularly foreign investors – agree to lend, and therefore in the level of the debt burden). This risk premium effect is also increased among emerging countries due to the slower availability of macroeconomic data which is also sometimes less coherent, a shortcoming in the information system that can increase investors’ sentiment of mistrust.

Moreover, apart from the effects of discretionary action by governments, debt dynamics are also subjected to the effects of the economic environment. As in the case of developed countries, buoyant activity is at the origin, via the cyclical component of the primary balance, of higher public revenues and less expenditure (even if automatic stabilisers such as unemployment are less significant than among developed countries). Furthermore, buoyant activity will be favourable to the debt ratio dynamics via the denominator effect. However, even more so than in developed countries, emerging countries’ debt will also be the result of: i) on the one hand, the trend in the price of commodities (which constitute a substantial proportion of revenues for some producing countries whose economy is not sufficiently diversified); ii) on the other hand, exchange rate fluctuations (for countries particularly exposed in terms of the proportion of currency-denominated sovereign debt). In this respect, it is noticeable that there is a significant correlation for the mentioned countries between exchange rate fluctuations and sovereign debt exposure to foreign currencies, with the least exposed countries being precisely those whose currency has undergone substantial depreciation in recent years (Brazil and Russia are for example less exposed, in contrast to the Philippines which is more exposed but whose currency has tended to appreciate in recent years, see graph 2).

What are the factors explaining the debt dynamics among emerging countries? 

Whereas for developed countries, the trend in the public debt is often presented as being the result of the primary balance, the interest rate/growth rate differential and stock-flow adjustments (or the difference in the debt stabilising balance and stock-flow adjustments), it is important, among emerging countries that are more exposed to exchange rate variations, to break down the debt burden into its components relative to debt denominated in local currency and in foreign currency. We therefore typically consider the trend in the debt ratio as:

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Where it, gt, pbt and ƒt represent respectively the real interest rate, the real GDP growth, the primary balance and stock-flow adjustments (which correspond to the difference between public deficit and change in debt, in particular to acquisitions of financial assets, to loans2 or the realisation of contingent liabilities such as the call of debts guaranteed by the government). Among emerging countries in particular, negative stock-flow adjustments may primarily correspond to episodes of debt relief and positive stock-flow adjustments reflect the country’s intention to implement subsidies to the economy without however causing a deterioration in the public deficit (via capital injections for example). 

For emerging countries, we can attempt to break down the interest rate, by considering that the interest rate at which a government finances itself is dependent on the allocation key between local and foreign currency denominated debt and the respective interest rates on these two types of debt. This breakdown leads to a debt ratio that is likely to evolve due to five terms: the debt burden denominated in local currency, the debt burden in foreign currencies (to which is added the change in the value of debt stock denominated in foreign currency due to changes in the exchange rate), the growth effect (i.e. the “denominator” effect), the effect of the primary balance (i.e. of the fiscal policy) and stock-flow adjustments. It is worth noting that, here, stock-flow adjustments are calculated as the difference between the total change in the debt ratio from one year to another and the contribution of the terms related to the debt burden, changes in the exchange rate, growth and the primary balance3 (i.e. as the residual).

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Each sovereign debt has its specific features

Debt ratio dynamics have proved to be very disparate over the last five years for the countries on which we focus. Turkey and the Philippines (characterised by a primary balance surplus and very dynamic activity) have seen their debt ratio decline significantly, whereas South Africa, Russia and Brazil (more recently) have experienced a dynamic, significant upward trajectory driven by albeit different factors. 

Turkey and the Philippines saw their debt ratio decline respectively from 42% to 32% of GDP and from 43% to 37% of GDP between 2010 and 2015. For both these countries, this decline can be explained mainly by substantial growth in GDP, which is at the origin of a favourable denominator effect on the debt ratio, and by a significant primary balance surplus. In addition, both these countries benefit from a relatively contained debt burden:

  • In the Philippines, the risk premium on foreign currency debt has remained at very low levels (see graph 3) and the currency has rather appreciated in recent years; these two factors have not therefore had a significant adverse effect on the debt burden denominated in foreign currency (representing more than a third of its public debt). Moreover, the value of the stock of foreign currency debt has been slightly reduced due to the sharp appreciation of the Philippine peso in 2012 and 2014 in particular;
  • In Turkey, the depreciation of the Turkish lira has been more substantial (increasing the value of foreign currency debt in 2011, 2013 and 2015), but the lower exposure to foreign currency debt (less than 30%) and the risk premiums which have not exploded (as recently in Brazil or Russia for example) have generally helped limit the impact of the debt burden on the increase in the debt ratio.

In contrast, South Africa, Brazil and Russia saw their debt ratio increase respectively from 35% to 50% of GDP, from 63% to 74% of GDP and from 11% to 18% of GDP between 2010 and 2015. However, this debt dynamic can be explained by different factors, specific to each of these countries: 

  • In South Africa, it has been driven by a primary balance deficit and heavy local-currency debt burden, accompanied by a less buoyant economic environment than in other countries;
  • In Brazil, the debt burden has had a significant adverse effect since 2010. Real rates on local currency denominated debt (constituting around 95% of Brazilian sovereign debt) were very high for Brazil over this period. Whereas prior to 2014, this burden was offset by dynamic activity and a primary surplus, the economic recession and the associated primary deficit in 2015 contributed in the same direction, taking the increase in debt to +10% of GDP that year; 
  • As for Russia, it saw its debt ratio increase mainly due to a primary balance deficit, in 2010 and since 2013, the debt burden remaining very low, due to both a low debt ratio (13% on average over 2010-2015), but also due to relatively low interest rates.

Ultimately, it therefore emerges that the debt of these countries, and emerging countries generally, is the result of very different situations, depending not only on the economic situation within each country, but also the ability of these countries to implement both an effective fiscal policy and convince the markets of their credibility (in local or in foreign currency) but also control exchange rate fluctuations via a resolute monetary policy (to avoid the explosion of the debt burden in foreign currency, if the country is exposed to
currency fluctuations). With regard to 2015, it is clearly Brazil’s sovereign debt that appears to be the most unsustainable here, while activity and the public finances will remain weak in 2016 against the backdrop of a political crisis that is likely to further increase investors’ mistrust, driving rates still higher (even if the situation is currently shifting towards more favourable perspectives). South Africa’s debt also merits being closely monitored, insofar as it is likely to suffer from the effect of high interest rates for some time to come, this effect not being counteracted by an activity that looks set to remain sluggish in the short term. That said, South Africa’s debt dynamics are nevertheless expected to benefit from the gradual reduction in the primary deficit (according to WEO forecasts in April 2016, the primary balance is expected to move back into  ositive territory in 2017). Finally, Russia, which is still in recession in 2016, is expected to see its public finances continue to be affected and see its realinterest rates rise with the gradual decline in inflation. That said, it should still be able to benefit from its low debt ratio and also from higher oil prices compared to 2015, which, if it manages to avoid further depreciations in the rouble, should limit the increase in debt mainly to the primary deficit effect (which could be lessened by targeted budgetary consolidation measures).

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1 For a prospective study presenting stochastic simulations of emerging countries' medium-term public debt trajectories, see "Which lever can enhance sustainability in emerging market countries ? A stochastic approach to better grasp public debt dynamics", Amundi Working Paper WP-53-2016.

2 These financial transactions result in an increase in gross public debt but are not considered as an expense since they are the counterpart of an increase in financial assets.

3 Accordingly, stock-flow adjustments do not include changes in the foreign currency debt value due to fluctuations in the exchange rate, since this term is isolated in this breakdown.

 

 

 

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PARET Anne-Charlotte , Strategy and Economic Research at Amundi
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Emerging sovereign debt: interpretation of recent trends
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