Post-COVID: Dealing with the emerging market debt overhang
Although the COVID crisis is affecting all economies (Baldwin and Weder di Mauro 2020), emerging economies are in a weaker position than developed economies to absorb its fiscal costs.1 In developed market (DM) economies, with credible institutional frameworks and relatively developed financial markets, most governments can run substantial government deficits without driving interest rates and inflation higher. For emerging market (EM) economies (with the notable exception of China), borrowing constraints are more likely to be binding, especially in a world where DM governments will also be borrowing heavily.2
In a recent paper (Daly et al. 2020), we assess the impact of the COVID-19 crisis on EM government deficit and debt levels, and the fiscal adjustments that are likely to be required in the aftermath of the crisis.
Estimating the COVID fiscal impact in 2020 and 2021
To estimate the impact of the crisis on fiscal balances in 2020 and 2021, we incorporate the effects of both the discretionary fiscal easing measures announced in response to the crisis and the impact of weaker growth on budget balances. We do not include the potential cost of loan guarantees provided in many countries, so we view the risks relative to our estimates as being skewed towards larger deficits. To help ensure cross-country comparability, we derive our own estimates of the impact of growth on fiscal balances on a consistent basis, before inputting the latest Goldman Sachs growth forecasts for each of these economies.3
Our primary (ex-interest) balance estimates for 2020 and 2021 are set out in Figure 1 (with the country ordering determined by the size of estimated primary deficits in 2020). On a regional basis, we find that primary deficits are likely to widen in Asia from 1.4% of GDP in 2019 to 5.5% of GDP in 2020, in Central and Eastern Europe, Middle East and Africa (CEEMEA) from 1.3% to 6.6%, and in Latin America from 0.3% to 5.8%. In 2021, as the impact of discretionary fiscal easing measures drop out, we expect primary deficits to improve on a sequential basis but remain materially wider than pre-crisis levels.
Unsurprisingly, we find that the largest deteriorations in fiscal balances are likely to take place in oil producers, including Saudi Arabia, Nigeria, and Russia. In CEEMEA, we also expect deficits to widen considerably in South Africa, Israel, Kenya, and Turkey. In Asia, the largest fiscal deterioration is likely to occur in Thailand and China (reflecting a large discretionary easing in these economies). In Latin America, we project the biggest primary deficits in Chile, Peru, and Brazil.
Figure 1 Primary (ex-interest) balance estimates
Our projections for gross government debt are set out on a cross-country basis in Figure 2 and as a time series for EM as a whole in Figure 3. In CEEMEA, we estimate that debt/GDP ratios will rise to high levels (>75%) in Egypt, South Africa, Kenya, and Ghana. In Asia, gross debt levels are also projected to reach high levels in India and China. In Latin America, we find that Brazil’s debt-to-GDP ratio could rise above 100%.
For EM as a whole, our projections imply that median government debt ratios will rise by around ten percentage points. This is less than the increase expected in the majority of DM economies, a reflection of the more restricted fiscal space, but it would nevertheless drive EM debt ratios in many countries to record highs.
Figure 2 Projections for gross government debt
Figure 3 Gross government debt in emerging markets over time
Estimating post-COVID fiscal adjustment paths
What fiscal adjustments will EM economies require following the COVID crisis to put themselves back onto a sustainable fiscal footing? While government debt levels in EMs are likely to rise by less than in DMs, the implications for fiscal policy in the long run could be more severe for EMs as real borrowing costs could rise rather than fall.
Using standard debt sustainability analysis, we estimate the primary balances required by EMs in the aftermath of the crisis under three different scenarios, which we view as spanning the range of potential outcomes:
1. The primary balance required to stabilise post-2021 debt on the assumption that real borrowing costs return to 2019 levels and that trend growth is in line with pre-crisis expectations.
2. The primary balance required to stabilise post-2021 debt on the assumption that the increase in real borrowing costs since the start of the crisis persists and that trend growth is one percentage point lower than pre-crisis expectations.
3. On the assumption that private debt markets are essentially closed to EMs, the primary balances required to cover existing interest payments and debt repayments as they come due.
Our results under these three scenarios are set out in Figure 4, together with our estimates of primary balances in 2021 as presented in the previous section (with the country ordering in this chart determined by the size of adjustment required under the second of the three scenarios).
Our analysis suggests that most EM economies will face a painful adjustment of fiscal balances in the aftermath of the COVID crisis. We also find that there are significant cross-country differences in the implied fiscal adjustments. Under the middle of the three scenarios set out above, our estimates imply that Asian primary balances will need to adjust from -2.6% to -0.7% (a fiscal tightening of 1.9 percentage points), that CEEMEA primary balances will need to adjust from -3.5% to +1.5% (a much larger tightening of 5.0 percentage points), and that Latin America primary balances will need to adjust from -3.0% to +1.5% (4.5 percentage points).
Figure 4 Three scenarios for debt sustainability
Six countries will likely need to make especially painful adjustments relative to the projected 2021 outcome: South Africa, Saudi Arabia, Kenya, Nigeria, Brazil, and Ghana. Three of these economies – Saudi Arabia, Nigeria, and Ghana – are highly dependent on oil revenues and the size of the eventual adjustment is ultimately likely to hinge on future oil prices. For South Africa and Kenya, the large estimated adjustments reflect relatively loose fiscal policy in recent years. The large estimated adjustment in Brazil reflects a high starting debt level.
It is also important to highlight the positive stories from our analysis. Our estimates imply that all countries in the Asia region will likely be able to sustain the post-2021 debt levels by running primary deficits, and many countries should be able to stabilise debt without large adjustments, including Russia and CEEMEA’s low yielders (with the exception of Romania). These positive stories reflect a combination of favourable real-rate and growth differentials and/or relatively contained increases in debt levels. India is a case in point in this regard: although India’s debt-to-GDP ratio is projected to rise to an estimated 85%, we estimate that it will be able to sustain its debt by running a primary deficit, as long as it can maintain its growth performance and real rates do not rise significantly.
Post–COVID: A difficult and risky adjustment for many, but not for all
Our analysis suggests that many EM economies will face painful fiscal adjustments in the aftermath of the crisis if they are to place government debt onto a more sustainable path. Developed economies also face this prospect but are more likely to be afforded the time to make these adjustments, and to do so while maintaining low borrowing costs. By comparison, EM economies are more likely to struggle to fund their increased borrowing needs at low rates, especially in a world where all governments are attempting to borrow much larger sums.
The IMF has reported that a large number of EM governments have already requested its help as a consequence of the COVID-19 emergency (Krahnke 2020, Marchesi and Masi 2020). We expect that number to grow.
Baldwin, R and B Weder di Mauro (2020), Economics in the Time of COVID-19, a VoxEU.org eBook, London: CEPR Press.
Carstens, A and H S Shin (2019), “Emerging Markets Aren’t Out of the Woods Yet”, Foreign Affairs, 15 March.
Daly, K, T Gedminas and C Grafe (2020), “Post-COVID – Dealing with the EM Debt Overhang”, EM Macro Themes, Goldman Sachs.
IMF (2020), Fiscal Monitor, April.
Krahnke, T (2020), “Doing more with less: How the IMF should respond to an emerging markets crisis”, VoxEU.org, 14 April.
Marchesi, S and T Masi (2020), “Debt restructuring in the time of COVID-19: Private and official agreements”, VoxEU.org, 4 May.
1 EMs face additional economic challenges relative to DMs, notably that the crisis is likely to result in a reduction in a number of foreign sources of income, upon which many EMs are especially reliant. These include reduced income from tourism and commodities, and a sharp falloff in remittance flows to EM economies owing to the lockdowns imposed in DM economies. On a more positive note, viral transmission rates and COVID-related deaths have been materially lower on average in EMs than in DMs, possibly owing to the effect of climate on transmission and the younger age structure of these economies.
2 While many EMs have overcome the ‘original sin’ of borrowing predominantly in DM currencies – a factor that has historically raised credit risks in times of stress – they still face what Carstens and Shin (2019) have described as ‘original sin redux’: because the majority of investors in EM local currency markets still have their performance judged on a USD basis, this can result in capital flight in times of stress, with the result that borrowing costs in many EMs remain pro-cyclical, even if credit risk is contained.
3 As an additional ‘sanity check’ on our results, we also cross-checked our estimates with the IMF’s latest fiscal projections (as set out in the April 2020 edition of its Fiscal Monitor).