After ten years of extraordinary accommodative monetary policy, marked by a 2020 peak of $19 trillion in negative yielding debt, it is understandable that debt levels have grown to record high levels. Markets have been complacent about this accumulation of debt because of low servicing costs and persistent deflationary trends. However, recent developments that point to resurging inflation are now forcing central banks to seriously consider restrictive monetary policies, including positive real rates, that would lead to much higher servicing costs for highly leveraged governments, households and corporations. This is worrisome for emerging markets which do not tend to fare well during tightening cycles occurring after long periods of debt accumulation.
As the following chart from the Financial Times shows, developing countries debt levels are at record levels and have grown precipitously since the Great Financial Crisis. The total debt to GDP ratio for developing markets has more than doubled since the GFC.
The following chart shows the evolution since the GFC in more detail for EM countries. Debt to GDP ratios have nearly doubled for total debt as well as for government, household and corporate debt. These ratios would be even worse if not for the extraordinary policies of financial repression and negative real interest rates pursued in 2021, as central banks allowed inflation to surge.
Debt levels of many key EM countries, shown in the chart below, are now at levels which leave them highly vulnerable to economic stagnation and financial crisis. Asian EM countries (with the exception of Indonesia) and Chile and Brazil are all at very high levels in absolute terms and relative to their histories. China (considering SOE debt and overstatement of GDP), India (considering overstatement of GDP), Brazil and Argentina all have levels of government debt close to 100%, a level which is considered highly debilitating by students of debt dynamics. China, given its capital controls and state-controlled banking system, may have the means to avoid financial disruptions but that is less true for the others, particularly for Latin American countries which have a history of rapid and profound shifts in capital flows and currently face strong capital flight from their own citizens.
The pace of increase in debt levels in recent years is also cause for concern. The chart below shows the increase in debt to GDP ratios over the past five years and during 2021. Historical precedents point to countries facing high risk of debt-related crisis following a surge of their debt to GDP ratio of 20% or more over a 5-year period. Last year was a year of acute financial repression by most central banks, so it is no surprise that debt levels came down for most countries. We can see the positive impact that this had for Brazil, in the next chart which shows how interest rates lagged inflation. Unfortunately, as the Scotiabank chart projection below shows, this effect will reverse in 2023, leading to high real rates.
Below, we focus on several key EM countries, each with its own vulnerabilities.
China
Debt levels have more than doubled since the GFC. If we assume that GDP figures need to be adjusted downwards by 20-25% to make them comparable to other countries, then debt ratios could be approaching 350%. Government debt has more than doubled over this period, and if we consider that almost all corporate debt is held by SOEs, then government debt would be well above 100%. The issue in China is not government solvency as the state has all the tools to keep the financial system operating smoothly. Rather, the vulnerability is that very high debt levels are choking the economy, and that the economy relies on unproductive debt-fueled growth to sustain growth. The consequence is that future growth levels can be expected to be low.
Brazil
Brazil’s debt levels are much too high for the economy to function properly and condemn the economy to low growth unless a serious fiscal reform or a productivity miracle occurs. Brazilian debt levels are at record high levels and they have risen by 60% since the GFC, a period during which growth and investments have been very poor. The government debt ratio has risen by 50%, to finance current spending, while corporate debt has risen by 70% and household debt has doubled. Government debt will likely reach 100% over the next year, which is much too high for a country with a structural deficit and which suffers from capital flight and political turmoil. Unlike in China, Brazil’s banks are private and managed very conservatively.
Korea
Kore’s debt ratio has risen by 50% since the GFC and is now one of the highest in the world. The government debt ratio has doubled over this period but remains at reasonable levels, and corporate debt has risen by 30%. Household debt has risen by 50% to 107% of GDP, an exceptional level, even higher than that of the consumption-happy United States. These very high debt levels would become a significant burden for the economy if interest rates rise, and could be a source of popular unrest with political consequences.
The Fed’s decade-long experiment in free money now may be at its end, leaving behind mountains of debt everywhere. Already weakened by the pandemic, political tensions and slowing growth, many emerging markets will add higher interest bills to their woes.