- In a new NBER working paper, top economists Carmen Reinhart and Kenneth Rogoff review EMDEs’ debt reduction options.
- To reduce debt post-pandemic, EMDEs could adopt either orthodox (e.g., cutting budget deficits) or heterodox (e.g., financial repression) strategies.
- With growth and inflation potentially moving against EMDEs post-pandemic, the authors emphasise the increasing importance of fiscal consolidations.
Although a lifeline for many, the fiscal splurge during the pandemic made 2020 the largest single-year rise in global debt since at least 1970. It rose by 29pp of global GDP. And in emerging markets and developed economies (EMDEs), total debt reached 206% of GDP (Chart 1).
While exceptional, the yearly spike is just the crest of a decade-long global debt wave. Nine in 10 EMDEs now have more debt than in 2010 and, in over half of these, debt has risen by more than 30pp of GDP. With the interest burden on these debts rising, what can EMDEs do?
This question is the focus of a new NBER working paper by Carmen Reinhart and Kenneth Rogoff. They review the policy options available for EMDEs should their debt trajectories ultimately prove unsustainable. They conclude that:
- EMDEs should not rely on high growth alone to lower current debt burdens. Instead, they should focus on fiscal consolidations and privatisations in the short run.
- Higher inflation will likely worsen EMDEs’ debt burdens, especially if the debt is denominated in a foreign currency, given it will most likely come with currency depreciation.
- The authors expect debt defaults to become more common among EMDEs after the pandemic, and debt restructurings are now more complicated than ever.
The EMDE Debt Landscape
Globally, government debt registered the fastest single-year jump since 1970. And it rose to its highest level in half a century: 97% of GDP. Government debt rose in almost nine-tenths of countries, and at its fastest pace in at least half a century in a quarter of countries. In EMDEs, it has reached 63% of GDP – the highest since the Latin American debt crisis.
Private debt also rose at a record pace. In EMDEs, private debt rose by 17pp of GDP, the largest single-year increase on record, to a high of 142% of GDP. Moreover, EMDE external debt, which aggregates private and public debt, rose by 2pp to 30% of GDP in 2020.
As the stock of debt rises, the interest burden, or net interest payments (the difference between primary balances and fiscal balances), can rise even when interest rates are falling. This has been the case in EMDEs since 2014 (Chart 2). Consequently, over half of the 73 countries eligible for the Debt Service Suspension Initiative (DSSI) in 2021 are either in debt distress or at high risk of distress.
The interest rate is offsetting financial distress in some countries. Since the Napoleonic Wars in the early 1800s, the global real interest rate has trended downwards at a pace of 1pp every 50 years. Since 2000, this pace quickened to 3pp.
This is good news because a lower interest rate, and in some cases a negative real interest rate, on government debt expands the capacity to borrow. In 2020, secular stagnation theorist Larry Summers notably argued that governments can now afford to aggressively stimulate the economy in recessions without having to take offsetting steps to bring debt back down afterwards.
Yet in EMDEs, the interest rates paid are nowhere close to zero. For some, the interest rate has even risen because of sovereign credit rating downgrades, which have been increasing in recent years. Also, as advanced economies start to normalise policy, expect interest rates to turn even more against EMDEs moving forward.
The Orthodox Approach to Debt Reduction
With rising debt levels and greater risks of default in EMDEs, policymakers can take any of the following ‘orthodox’ approaches to deal with high debt. First, they can rely on achieving high rates of growth, which principally served to reduce government debt among more than 50 EMDEs in 1980-2010. The idea is that growth in excess of the cost of borrowing (the interest rate) reduces repayments.
While appealing, the authors argue against EMDEs relying on higher growth moving forward. In the past, high-growth episodes have not followed periods of elevated debt levels, such as this one. This is because EMDE policymakers have had to increase taxes or reduce government spending to service debt, and any associated macroeconomic uncertainty has crowded out productivity-enhancing private spending.
The few examples where accelerating growth reduced EMDE debt were after one-off shocks such as wars. While COVID-19 is a one-off shock, debt had been increasing pre-pandemic from broader spending pressures and revenue weakness, so such examples are unlikely to be relevant now. Moreover, the possibility of higher interest rates from higher inflation and lower potential growth post-pandemic could also worsen debt burdens.
Instead, the paper argues for a period of fiscal consolidation in EMDEs, mainly because these countries can still rely on monetary policy to support growth, unlike advanced economies. Servicing, or even accumulating more debt at current levels, has the potential to instil default fears. This could ultimately reduce financial market access, which would be very costly.
Privatisation is another potentially useful debt-reduction policy, especially in the short run. It can also increase growth and lead to greater economic efficiency and firm profitability. However, evidence from Latin America and Greece shows it does not necessarily improve the long-term trajectory of government finances. And it can increase inequality. To make it work, additional reforms, such as easing market entry to foreign ownership and creating independent regulators, are required.
The fourth and final orthodox approach to reducing debt is a wealth tax. Since the global financial crisis (GFC), there has been renewed interest in wealth taxes, stemming from mounting concerns about an unequal distribution of wealth. These taxes have mostly been repealed in OECD countries. In EMDEs, wealth taxes have also had limited success in the past, as most rich taxpayers hold money offshore and the government’s enforcement capacity is typically lower.
Inflation can also reduce debt burdens, but engineering just the right amount is very difficult. It would involve increasing nominal incomes faster than nominal interest rates. And, even if this was achieved, policymakers would need to accept very high inflation over a very long period to make a significant dent in today’s debt-to-GDP ratios. This would undermine confidence and erode hard-won EMDE central bank credibility.
Also, such a strategy only works with a larger share of long-term debt and domestic currency-denominated debt. That is not the case in many EMDEs. In fact, higher inflation on foreign currency-denominated debt could raise debt service burdens, which is partly why exchange rate crises have often accompanied inflation crises.
Instead, policymakers could use capital controls and financial sector regulation to artificially tilt the balance between the real interest and growth rates. Financial repression can trap savings in specific debt instruments, impose limits on interest rates or lending, or discourage competition in the financial system through state ownership of banks and barriers to entry. During the 1970s and ’80s, it was an important mechanism and largely considered successful, creating estimated fiscal savings of up to 5% of GDP.
During the GFC and pandemic, several countries, including in EMDEs, implemented asset purchases and interest rate controls. However, in the case of interest rate controls, financial repression can undermine the independence of central banks and reduce growth through altering saving and investment incentives. Also, financial repression is becoming more difficult to deploy and, once in place, is difficult to unwind. So, financial repression is mostly only attractive when debt is very high and less distortionary options are precluded.
The Worst-Case Scenario
Governments always have the option of default. Over the past 200 years, the average EMDE defaulted over four times, and each default lasted on average three years. In most cases, debt was owed to foreigners, was denominated in foreign currency, and was adjudicated by foreign courts.
Where possible, restructuring takes place, with haircuts of 13-73% of net present value. This is a better option that improves the growth outlook of distressed countries. Yet it comes with long-term costs, such as higher bond yields, weaker balance sheets and lower financial stability.
Looking ahead, the authors believe EMDE debt defaults will become more common after the pandemic-induced debt runup. They also believe debt restructurings are now more complicated than ever. For example, the creditor base for low-income country debt has become more fragmented – a larger share of debt is held by residents, by non-traditional creditors and on non-concessional terms.
If default occurs and debt restructuring is delayed, this will have larger negative implications for GDP. This is because it deeply cuts back public investment, which erodes the foundation of future growth. Evidence also exists that debt restructuring becomes more delayed when the credit country has stronger growth.
Given the rapidly rising debt burdens and the substantial uncertainty ahead, the NBER paper provides a timely literature review of the policy options available to EMDEs. Reassuringly, two of the most prominent economists in the field have signed off on it, making this review a good starting point for further research.
Kose, A. M., Et Al., (2021), The Aftermath of Debt Surges, NBER, (Working Paper 29266), https://www.nber.org/papers/w29266
Sam van de Schootbrugge is a Macro Research Analyst at Macro Hive, currently completing his PhD in international finance. He has a master’s degree in economic research from the University of Cambridge and has worked in research roles for over 3 years in both the public and private sector.