Public debt levels, as a percentage of GDP, have increased significantly in both developed and emerging markets this year, as economies shrank amid the global crisis created by COVID-19 and governments borrowed and spent heavily to offset this contraction.
Although emerging markets in general deployed less fiscal stimulus than their developed counterparts, their public debts as a proportion of their GDP are still expected to hit historically high levels. As the chart shows, they are at their highest points since the mid-1980s and exceed the levels after the Asian and Russian crisis in 1997-1998.
Historically, such increases in emerging markets’ public debts have been followed by restructurings or debt re-profiling; some governments also pushed for higher inflation to erode the real burden of their borrowings, effectively monetising their debt.
Now, though, emerging markets have mostly moved to inflation-targeting regimes and have preferred to keep inflation low to bolster the credibility of their policy frameworks. This was made easier by high growth rates and stable currencies, which together with other factors kept their public debt levels under control.
Can we rely on this more recent behaviour to hold, or could some emerging markets return to their old ways? This latter possibility perhaps explains why yield curves in emerging markets are steep: some investors may already be pricing in the risk of higher inflation.
We believe the picture is different now than in the past, however. First, we don’t expect any major emerging markets to default on their external debt, whereas historically this was a much greater risk.
What has changed is that, as we see in the chart above, the share of their debts denominated in foreign currencies is much smaller than in the past. This is true for private as well as public debt, as credible policy frameworks and low inflation have helped local issuers borrow in domestic currencies and so cut their foreign-exchange risks.
However, the counterweight to this lower risk of default is that emerging markets may now be more inclined to tolerate higher inflation to monetise their debts. In addition, they could engage in other forms of ‘financial repression’ – such as keeping rates lower than would be suggested by growth and inflation dynamics, obligating investors to hold government bonds – or attempting other forms of yield curve control.
To examine which countries would benefit most from inflating away their debt, we constructed a simple scorecard. We assume that the countries with the highest debt levels and lowest share of hard-currency debt would be most ‘tempted’ to use inflation to reduce their public debt levels, given their relatively lower risks of a disruptive debt selloff or capital flight.
We also think that a higher share of foreign investors being present in the local market may increase the appeal of inflation over other forms of financial repression (such as regulation to force investors to buy debt, as this is more easily imposed on local investors).
The table below summarises our analysis.
This simple exercise would suggest that countries such as South Africa, Brazil, India, Malaysia, and Mexico have the most scope for using inflation as a means to reduce their public debt.
At the other end of the scale, the Philippines, Poland, Indonesia, Russia, Chile, and to some extent Turkey (where inflation is already high) have less space to use inflation as a tool of financial repression.
Motive and means
Of course, policymakers can’t easily create higher inflation after reducing it so well over the past two decades. So do any countries seem able to engineer inflation?
To assess this question, we look at two indicators: inflation credibility and the openness of the economy. Both theory and experience tell us that upside inflation shocks tend to dissipate in countries with well anchored inflation expectations, so attempts to increase inflation may not stick. And no country is effectively an island these days: the higher the share of its goods traded internationally, the harder it is to insulate the economy from external inflation trends.
We plotted countries according to these two indicators below.
What we find is that among the countries with the space to inflate away their debt, only Brazil, India, and Colombia realistically have the economic conditions to make higher inflation stick. This would also suggest that yield curves in these countries have less scope to flatten, even as their economies recover from the COVID-19 shock.
For the others with low inflation, anchored inflation expectations, and open economies, the more likely approach to public debt will be to keep policy rates low for longer – similar to the course expected for G3 central banks. In these economies, we may also see less focus on short-term inflation volatility (representing a departure from ‘monetary dominance’), which would also mean more volatile exchange rates. Some countries may also attempt other forms of financial repression, such as a regulatory push to hold more domestic bonds.
For international investors, such financial repression would create more stability in long-term yields, but also fewer opportunities to invest in fundamentally sound economies when yields move above what’s suggested by fundamentals. Higher currency volatility would also likely require more foreign-exchange hedging, but this could be made cheaper by short-term rates kept low by dovish central banks.