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18 Oct 2024
3 min read

EM fiscal outlook: Running out of other people’s money

It’s that time where most countries prepare their budgets for next year. So let’s take this opportunity to reflect on the outlook for emerging market sovereign debt. A handful of countries are likely to see their debt rising from already high levels. Brazil’s outlook is particularly worrisome.

EM fiscal

The government debt of the median emerging market is forecast to hit a 28-year high in 2026 at slightly above 50% of GDP.[1] The projections take official budget targets and medium-term fiscal frameworks at face value.

This debt level compares favourably with advanced economy levels. For example, the US, UK and France all have government debt above 100% of GDP. Even if we express debt relative to government revenue on the grounds that taxing and repayment capacity vary with the level of development, emerging markets come out on top.

However, the median masks large differences across emerging market debt dynamics. The first chart below shows that some countries with already high debt in 2023 (horizontal axis), show the largest increases in debt through 2026 (vertical axis). These countries are Brazil, Hungary, Israel Thailand and Poland.

Budgets in Israel and Poland are under pressure from increased defence spending. Hungary and Thailand are led by populist parties, while Brazil is burdened by a welfare system that is not fit for the country’s demographic transition.

Israel and Brazil also show significant budget overruns in the year through August – 2.7% and 1.1% of GDP, respectively – suggesting debt could rise even more than forecast.

The increase in the debt-to-GDP ratio over 2023-26 can be broken down into two parts: debt service on existing debt and the deficit excluding debt service, the so-called primary deficit. The former part is no longer under the control of the authorities and can lead to rapid changes in debt dynamics. It is this part that Warren Buffett referred to when he said “Debt is like a snowball headed downhill”.

For Brazil, debt dynamics are almost exclusively driven by debt service on existing debt (adjusted for a growing economy), severely reducing policy space. Interest rates shot up with inflation after COVID-19 and while nominal GDP growth should return to normal in 2025-26, debt contracted at higher interest rates will only mature in four years.

In the case of Hungary and Poland, the interest-growth differential is much lower than in Brazil (as is debt in the case of Poland). However, since it was deeply negative in previous years, more fiscal effort is required in 2025-2026. For India and South Africa, on the other hand, the interest growth differential looks likely to improve over the next few years.

What is market pricing suggesting?

Brazil has the steepest interest curve among our set of 18 emerging economies. Hence, markets recognise the risks associated with its debt sustainability. South Africa’s risk premium is similarly elevated, which against the above analysis looks exaggerated to us.

Fiscal profligacy also has implications for inflation as evidenced by Brazil’s recent interest rate hikes. For Brazil, meanwhile, investors are pricing in 225bps interest rate hikes over the next six months. For Poland, which looks likely to see a similar increase in debt, investors are pricing in 35bps of cuts.

Turkey and India have some of the best debt dynamics in our sample, as shown by the favourable interest-growth differential. This is one of several reasons that in the Asset Allocation team we currently favour long exposure to the lira and the rupee.


 
[1] Here, we look at the top 18 emerging markets, excluding China. China with its blurred line between public and private sector debt does not fit easily into a cross-country analysis.

Emerging Markets
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Erik Lueth

Global Emerging Market Economist

Erik identifies investment opportunities across emerging markets. He uses quantitative models, past experience and lots of common sense. Prior to joining LGIM, Erik worked for…

More about Erik

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