Back in April, nervousness about external debts reached its peak when highly-respected economists Carmen Reinhart and Kenneth Rogoff suggested emerging economies with less than a AAA credit rating be offered a moratorium on all their external debt service payments.
Although such a proposal might make sense if emerging economies were actually facing any serious shortage of access to foreign exchange, it is a difficult case to make. What we should worry about is not the external debt of emerging economies, but rather the large increases in government debts denominated in their own currencies.
In the first six months of 2020, borrowers from emerging economies issued more than $400 billion of Eurobonds to international investors, up by one-fifth over the same period in 2019. Most of these bonds were sold by borrowers with relatively high credit ratings, but many of the poorest countries do not fear for their access to international capital markets - largely because the US Federal Reserve increased global supply of dollars to a point where their availability is beyond question.
Much of the panic about emerging economies’ external debt comes from ‘sticker shock’ - the bald fact that developing countries’ external debt rose by $4.1 trillion in the decade to 2018 generates much hand-wringing.
But the increase in gross external debt of developing countries looks a lot scarier than the net increase in debt, which sets off a country’s foreign assets - mostly foreign exchange reserves - against its liabilities. And it is net that counts.
At the end of 2018, foreign exchange reserves covered 70% of the external debt of low and middle income developing countries - much lower than a decade ago, when that coverage was above 100%. But in the 1980s and 1990s – two decades of financial instability largely because of excessive foreign debt – the coverage was 15%. By that measure, we are far from crisis territory.
Complacency about the external debt burden of developing countries is quite wrong. But, if complacency is misplaced, so is panic.
The debt growing most worryingly is the domestic debt of governments. There are large, systemically important emerging economies who will suffer eye-watering increases in public debt this year thanks to a combination of collapsing GDP and the fiscal effort needed to save lives.
In Brazil, public debt is rising from 75% GDP last year to a level that could top 100% in 2020. South African public debt is rising from just over 60% last year to something close to 80% GDP. These are truly unprecedented levels of debt.
So why worry about a government’s domestic debt? These are debts which are denominated in these countries’ own currency. So surely the central bank can just print the currency needed to repay their obligations if more conventional solutions – such as tax increases – will not work.
But it is one thing for the US Federal Reserve to increase supply of dollars on a massive scale, since the world is hungry for them - it is quite another thing if emerging economies do the same with their currencies which almost entirely lack the many attractions of the dollar. That remains the currency of the pre-eminent global superpower whose capital markets offer legal certainty and depth of liquidity. And other highly developed economies have a similar privilege.
And yet printing money – in effect, asking the central bank to finance budget deficits – does seem as though it could become a more attractive option for many emerging countries. Importantly, international fund managers have lost interest in buying bonds issued by emerging economy governments in their local currencies. Just a few years ago, foreign investors owned more than 40% of South Africa’s public debt. That has fallen sharply to 30% and is unlikely to rise.
Monetising budget deficits was once anathema, since it was routinely associated with uncontrolled rates of inflation - bad news not only for firms trying to decide whether to invest but also for the poor, who suffer disproportionately when inflation accelerates.
Right now there are emerging economies – such as Indonesia – whose central banks lend directly to the government, and the sky has not fallen in. The rupiah has been remarkably stable this year. However, there are other examples – Argentina, Turkey – where central bank financing of government deficits has been associated with uncomfortably high inflation rates.
This needs careful watching. The biggest risk is the accumulation of public debt threatening longer-term growth. If firms stop investing because they worry about the risks to the value of their currency as domestic public debt explodes, emerging economies will have a tough time growing their way out of these debts.
It could be this, rather than the external debt of emerging economies, that is the biggest risk to the post-coronavirus economic environment in the developing world.