Can Emerging Markets Be Nonchalant About Their Debt?
How astonishingly economic orthodoxies change!
Fiscal austerity, once held up as gospel, is no longer an unquestioned virtue. The International Monetary Fund, which used to preach spending restraint as an article of faith, is now urging governments to loosen their purse strings. U.S. President Joe Biden’s budget was quite unapologetic about its borrow-and-spend spree. India’s budget for the current year deviated from the fiscal rules by opting for a higher-than-expected fiscal deficit and a slower-than-expected medium-term fiscal consolidation path. But even staunch fiscal hawks thought that was par for the course.
Why has the fear that piling on public debt is a sure-fire recipe for disaster given way to such nonchalance? No, it’s not economics that has changed; it is the real world to which economics applies that’s changed. We owe it to Olivier Blanchard, former chief economist at the IMF, for an explanation of what in fact has changed in the real world.
Why There’s Been No Debt Trap
Standard fiscal algebra tells us that if the average interest rate on debt exceeds the economy’s growth rate, the government’s budget will have to generate a surplus in the future to ensure that debt as a proportion of output does not explode. It is this intuitive reasoning that underpins the textbook assertion that if current spending is not financed by current taxation, it has to be paid for by future taxation.
Blanchard’s insight has been to note that since the 1980s, the average interest rate on debt has been, not higher, but lower than the pace of economic growth in much of the rich world. This turns the fiscal algebra topsy-turvy and allows room for the government to keep borrowing, albeit within limits, year after year without worrying about a debt explosion.
No future taxation will be necessary to pay for the debt since the low-interest rate acts as an implicit tax on investors, without their realising it of course.
Can’t Get Complacent
Is this nirvana then? Can governments pile on debt without ever worrying about repayment? Certainly not. As Blanchard himself acknowledges, the inequality – interest rate below growth rate – may not stay that way forever. It can turn the other way and drive the debt situation out of the Goldilocks zone.
Emerging markets, in particular, should never become complacent about a debt build-up, and for many reasons. For sure, they too typically clock growth rates higher than the average interest rate on their debt, but the inequality is much less robust in their case.
Better Watch Out...
Those emerging markets that borrow in hard currencies are particularly vulnerable. If foreign bondholders become skittish about the fiscal situation, they will sell the government bonds they hold, forcing the government to repay them in hard currency. A fiscal crisis will then snowball into an external payments crisis with enormous collateral damage.
But is an emerging market safe if it is borrowing in its own currency? There is no room for comfort in that case either, since foreigners lending in domestic currency will demand a higher premium to cover the exchange rate risk they carry.
The short point is that the debt comfort zone is much narrower for emerging markets regardless of whether they borrow in national or hard currency and regardless of whether the lender is domestic or foreign.
India is a stand-out example of this vulnerability. Its government has always borrowed in rupees and mostly from domestic lenders. Even so, fiscal pressures had in the past spilled over into the external sector. India’s bruising balance of payments crisis in 1991, and a near-crisis in 2013 were, at heart, a result of extended fiscal profligacy.
Hidden Welfare Loss
There is another dimension to the Blanchard analysis that is salient for emerging markets. The standard fear about government borrowing is that it would ‘crowd out’ capital from growth-supportive private investment. In rich countries, this is not much of a concern right now as low real interest rates suggest that there are few, if any, viable competing private sector projects.
The situation is different in emerging markets. Since they are typically short of capital, private investment should offer attractive returns. There is an opportunity cost therefore for investors in buying government bonds which should make them demand a higher yield.
It’s possible that government paper still commands a lower interest rate, but that is more likely because of financial repression mandating banks to hold a minimum level of government securities rather than a market signal about relative returns to public and private capital. Such repression entails a welfare loss, albeit hidden.
For emerging markets, the lesson to take away from Blanchard’s wise analysis is clear: they can’t let the guard down on debt sustainability. Experience over the last half-century holds out ample evince that markets are much less forgiving of fiscal excesses by them. They should borrow responsibly and within limits, and spend the borrowed money on infrastructure and capacity building so as to ‘crowd in’ rather than ‘crowd out’ private investment.
Duvuuri Subbarao is former Governor, Reserve Bank of India; and former Finance Secretary, Government of India.
The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.