Debt: Big EM’s Versus Low Income EM countries

Market Implications: In terms of financial stability, China’s ability to control debtors and creditors suggests that a major financial crisis can be avoided, though we remain concerned about weak banks. Low income EM countries have also seen a pick-up in debt/GDP, with borrowing in foreign currency meaning that eight countries are now in default and others are in distress. The Sri Lanka debt restructuring should be worth watching closely likewise the Ethiopia discussion on preemptive debt restructuring (with the IMF discussing a loan program and debt restructuring in tandem).

Figure 1: Total Non-Financial Sector Debt/GDP Since Q1 2007 (%)

Source: BIS (data to Q3 2022) 

End of Ultra-Low Rate Era and Debtors Problems

With debt levels coming back into focus, it is worth highlighting the major differences between China, other big EM countries and low income EM countries – we have already looked at this from a DM viewpoint (here). A major surge in total non-financial sector debt (government/household/corporate) is a concern, but it depends on the starting point and the composition. In China’s case (Figure 1), the starting point was below India in 2007, but now, the total non-financial sector/debt GDP is above other BRICS and above the U.S. (257%) and Eurozone (259%).

China has seen a split surge across government/households and firms. Firm debt/GDP at 163% is elevated by western standards. We have argued that this high level of China’s debt is unlikely to expand at the rate that occurred since 2007 going forward and this will mean less debt and credit fuelled growth. After the cyclical recovery in 2023-24, we see growth relapsing to below 5% and eventually to 3-4% (here).Only moderate productivity growth and little population growth are other reasons behind our forecast. The financial stability implications are different. A large part of the corporate debt is either state owned enterprises (SOE) or local government financing vehicles (LFGVs). In the worst case, SOE and LGFVs will likely be bailed out by local and central government. For example, in a recent article (here) we noted that China’s government swapped LGFV debt for local and central government debt in 2015. Additionally, in an emergency, given that China’s debt is in Yuan and overwhelmingly owned by domestic players, the Chinese authorities can instruct creditors to extend debt to zombie borrowers as they did during the 2020 COVID crisis. We do remain concerned that property developer debt will cause strains in rural banks (here), but China’s authorities will resolve this by takeovers rather than allowing failures of banks. Even so, measures to support weak debtors is an economic drag on China economy, as it restricts new good quality lending in the coming years.

 One of the key reasons that China debt is manageable is that it overwhelmingly in Chinese Yuan rather than foreign currency. This means that any adverse currency move has limited effects of debt, while the Chinese authorities have a lot of influence over domestic creditors in contrast to foreign creditors. This is also the case for other BRICS (Figure 1) and also other big EM countries such as Indonesia and Mexico (Figure 2). While overseas investors do hold debt instruments in domestic currencies it is not excessive and is unlikely to cause major capital outflow problem unless an extreme domestic shock is seen. It is also worth mentioning that overall EM total non-financial sector debt/GDP is distorted by China debt growth and it is better to look at disaggregated numbers. 

Figure 2: Total Non-Financial Sector Debt/GDP Since Q1 2007 (%)

Source: BIS 

Managing domestic debt does still require discipline and credibility however. If government debt/GDP or total non-financial sector debt gets too large, then it can force up real and nominal interest rates and cause market shocks – especially if the average stock of debt is short maturity. The good news is that most big EM have control of inflation (e.g. China) or have taken tightening measures to bring inflation back down towards targets (e.g. Brazil/Mexico and South Africa). This should see real and nominal interest rates falling into 2024-25 and helping to ensure debt payments remain manageable. Argentina and Turkey of course are different having lost control of inflation, which in Argentina caused a debt crisis as foreign currency borrowing was higher than other EM countries. If Turkey could get a dramatic reduction in inflation, then its debt could be manageable but this probably requires opposition parties to win and then successfully introduce orthodox economic policies that bring inflation down and rebuild credibility (here). Meanwhile, Brazil average domestic government debt maturity of 4 years leaves it vulnerable to a shock, but India and South Africa average domestic maturity exceeds 10 years and makes government debt manageable (Figure 3).

Figure 3: EM Domestic Debt Structure and Refinancing Needs (%)

Source: IMF GSFR April 2023 

The surge in South Korea and Chile debt since 2007 is worth looking at in Figure 2.South Korea comes from a 38% rise in household debt/GDP and 37% in corporate debt/GDP. However, South Korea is now has a high per capita GDP and the overall debt is similar to the U.S. and Eurozone, though debt could still restrain growth in the 2020’s.In terms of Chile, the surge in debt has largely comes from the corporate sector, though it peaked in 2020. Additionally, part of the corporate debt is to the mining sector, which is Chilean based but a global industry. Two additional measures that economists look at is the net international investment position and external debt sustainability and on these measures Chile is not sounding an alarm.

The real difference in EM is between the big EM countries that largely borrow in their own currencies and low income EM countries that have borrowed in foreign currencies since 2007. The IMF has estimated that 37 out of 69 low income countries are in debt distress or at risk of debt distress and 8 countries are in default. One of the critical issue is how debt restructuring occurs for the 8 countries in default and other that have not defaulted but are in distress (e.g. Ethiopia). This has become more complex as debt is no longer dominated by western governments and banks, but includes private sector creditors and China. China debt approach to debt restructuring is influenced by China economic and foreign policy agenda, rather than the traditional Washington based approach undertaken by the IMF and World Bank. China is more reluctant to consider partial debt forgiveness and has argued that the World Bank should not always be super senior in debt repayments. In the remainder of 2023, the Sri Lanka debt restructuring should be worth watching closely likewise the Ethiopia discussion on preemptive debt restructuring (with the IMF discussing a loan program and debt restructuring in tandem).