Governments need to strategically use financing opportunities while safeguarding their economies from the risks of runaway debt and poor debt management.
A rosier post-pandemic economic outlook for advanced economies is supported by the faster pace of vaccines being rolled out compared to developing countries, as well as stronger proactive fiscal responses being deployed now and in the future.
But why aren’t developing and emerging economies opening their purses enough to shore up their economies, despite suffering from the economic impact of the pandemic no less than their advanced peers? Developing countries are facing severe economic and social damage due to the sheer size of informal economies with vulnerable, low-income workers who cannot enjoy the luxury of work from home arrangements, and face poor hygiene and healthcare conditions.
While advanced economies recorded large increases in fiscal deficits in 2020, developing countries’ fiscal responses have been much more constrained. According to the Institute of International Finance, the global debt to GDP ratio by government rose to 105.4% by Q4, 2020 from 88.3% in 2019. The ratio for emerging markets grew to 63.5% from 52.4% during this period, which is a significant increase but overshadowed by a whopping more than 20 percentage point increase in advanced economies to 130.4% from 109.7%.
Why are developing countries more constrained in expanding fiscal stimulus packages even under much more favorable public debt conditions compared to advanced countries?
Optimal public debt ratio has always been a controversial topic among researchers and policy makers. An analysis by renowned economists Carmen M. Reinhart and Kenneth Rogoff suggested median growth rates for countries with public debt over roughly 90% of GDP are about 1% lower than otherwise.
The Joint World Bank-IMF Debt Sustainability Framework for low-income countries as of March 2021 sets the present value of total public debt at 70% of GDP as the threshold for strong debt-carrying capacity. Below this threshold is classified as medium (55% threshold) and weak (35% threshold) debt sustainability respectively.
The European Union’s Stability and Growth Pact requires public debt must not exceed 60% of GDP. Different criteria could sow the seed of confusion, but at the same time indicates how difficult it is to come up with a unified criterion governing the fiscal policy space.
Although most of the emerging Asian economies maintain relatively lower debt to GDP ratios—emerging Asia’s average debt to GDP ratio is 63.5% in Q4, 2020, much lower than the global average of 105.4% according to IMF data—they may not be complacent for the following reasons.
First, history attests that a county’s debt to GDP ratio continues to grow as its economy matures due in part to the progress in population ageing and expanding social entitlement requirements, and further by the nature of the expenditures using debt financing, which usually requires periodic refinancing instead of eventual repayment. These factors will only add to the medium-to-long term debt burdens in emerging Asian economies.
Second, while it’s generally believed that advanced economies have capacity to sustain a high debt GDP ratio, developing countries are more often than not suspected of lacking such capacity, as high debt levels often prompt credit rating downgrades by global credit rating agencies alongside withdrawals in capital inflows and a plunge in local currency values.
Asian economies need to look beyond the simple numbers and look for ways to wisely use debt financing opportunities while safeguarding their economies from the risks of runaway debt.
Third, although extremely low interest rates are conducive to cheap borrowing environments, enlarging the borrowing size itself could pose continuous strains on debt-to-GDP ratio unless supported by robust economic growth.
In terms of the pandemic, we are not out of the woods yet. Now is not the time to withdraw proactive fiscal expansions. Many countries have to continue to strengthen fiscal responses and beyond, to bounce back from the economic downfall and ensure sustainable and resilient economic recovery.
So, the key question is how to reconcile this imperative with the concerns about ballooning fiscal deficit and debt-to-GDP ratio in emerging countries in Asia.
The first consideration is how to use the proceeds of debt. How effectively these resources are used without waste will affect their contribution to economic recovery and growth, which will determine the debt-to-GDP dynamics in the medium-to-longer term.
Second, transparency and effective communications with the market is no less important than the borrowing itself. The foreign investors who will purchase the debt instruments will also become potential sellers if the debt issuing country’s debt servicing credibility is questioned.
While conducting good investor relations engagements is important for the success of borrowing, the government needs to further communicate with market participants and investors on the economic underpinnings of debt financing and how well debt is being managed.
Third, in order to reduce excessive reliance on external financing, countries need to develop the local currency bond market further, which should also include broadening the domestic investor base.
The final consideration is that to prepare for an eventual exit from the ultra-loose monetary policy environment, economies need to broaden their revenue base through domestic resource mobilization efforts to strengthen debt servicing capacity.
There may not be a perfect answer to the question of what is an optimal debt level. However, Asian economies need to look beyond the simple numbers and look for ways to wisely use debt financing opportunities while safeguarding their economies from the risks of runaway debt accumulations and poor debt management.