Unanticipated debt increases hinder growth and drive inflation in emerging markets. Fiscal frameworks and buffers, consolidation strategies, and coordinated policies can mitigate these challenges and bolster resilience.
The accumulation of debt in emerging market economies increased markedly in the decade after the global financial crisis of 2007-08 due to lower global interest rates during that period and the resulting reduced costs of sovereign borrowing.
Debt soared further in the face of fiscal stimulus requirements due to the COVID-19 pandemic. In more recent years, during 2022 and 2023, elevated inflation in the post-pandemic period led to a tightening in global monetary policy. High debt levels combined with higher costs of debt servicing triggered concerns on debt sustainability.
Inflationary pressure has continued to subside throughout 2024, however, given the lagged effects of tight monetary policy as well as some easing in global commodity prices. The US Federal Reserve’s 50 basis point rate cut in September brought some breathing space for emerging economies also aiming to commence their monetary policy easing cycles.
However, given the resilience of the US labor market and stronger than expected economic activity, the pace of easing by the Fed could be slower going forward. This is compounded by the potentially inflationary impact of proposed policies on trade, immigration and tax by US President-elect Donald Trump.
Indeed, Fed rate futures imply only 75 basis points of cuts by the Fed by October 2025, compared to 125 basis points prior to the presidential election result on 5 November.
While some lowering in interest rates can be expected nonetheless, helping to alleviate some of the debt servicing burdens in emerging markets, interest rates will continue to remain elevated relative to the 2010s.
Amplified debt sustainability risks in emerging market economies pose significant challenges for policy makers. Set against this context, a recently published ADB Economics Working Paper and journal article examine the impact of unanticipated rises in debt on output and inflation in 34 emerging market economies over the period 2000 to 2022.
Several previous studies on debt and growth indicate that for levels of debt to gross domestic product (GDP) above 90%, a negative impact on growth can materialize. On inflation, persistent fiscal deficits and excessive debt can constrain the central bank from tightening monetary policy, leading to heightened inflation expectations.
Our analysis finds that real GDP significantly decreases after an unanticipated increase in public debt while inflation responds in the opposite direction. More specifically, the impulse responses indicate that following a 1% positive public debt shock, the level of real GDP decreases with a maximum impact of –0.015% around 2 years after the shock.
On the contrary, an unexpected increase in public debt is associated with a persistent increase in inflation around one year after the shock.
Our study also explores the domestic economic fundamentals that could affect the results. Higher initial debt levels, tighter domestic financial conditions, and lower income levels are shown to worsen the effects, particularly in relation to GDP. Emerging market economies also face more severe effects during recessionary periods.
Our findings have implications for policy makers aiming to enhance public debt sustainability. In particular, given that lower initial levels of debt or a declining debt trajectory can mitigate the negative repercussions of debt shocks on growth, longer-term fiscal consolidation strategies need to be prioritized. Building up fiscal buffers in good times can be an important contributory factor.
Recognizing that the optimal design of medium-term fiscal frameworks is challenging, policy makers should bear in mind the output and inflation repercussions of unanticipated debt shocks, which are more severe with high and growing debt.
In this environment, it will be imperative for national fiscal authorities to ingrain credibility into macroeconomic projection assumptions in conjunction with a well-anchored fiscal path. On the design of fiscal frameworks, appropriate fiscal rules can be helpful for supporting the soundness of public debt management and broader macroeconomic resilience. In this context, monetary and fiscal policies should be well-calibrated and coordinated.
Likewise, incorporating risk factors into fiscal frameworks can alleviate the effects of debt shocks on the economy. More broadly, this can also reduce debt sustainability exposure and create policy space for responding to shocks.
In addition, emerging market economies should be encouraged to devise and implement policies aimed at longer-term sustainable growth, given that shifting towards higher income boosts the resilience of both growth and inflation to debt shocks. Related to this, boosting efforts on raising tax revenue and mobilizing domestic financial resources will be important, including through broadening the tax base.
Source : Asian Development Blog
