Interest Costs Diverge Near Term for Emerging-market and High-debt, Low-Growth Advanced Economies

Credit outlooks for advanced and emerging-market economies will diverge in the near-to-medium term on debt-servicing costs as interest rates rise even though debt-to-GDP has risen sharply across most countries during the Covid-19 pandemic.

The exception, longer term, will be those advanced economies (AEs) with high debt, elevated tax burdens and low growth despite typically better market access, longer debt profiles and more favourable debt dynamics of AEs compared with those of emerging-market economies (EMEs).

The interest-payment burden is more important for assessing sovereign debt sustainability than the level of public debt itself.

Change in public debt and interest payments
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Our report published on 28 March: “Emerging markets face higher public finance risks as interest rates rise than advanced economies” based on a sample of 26 AEs and 22 EMEs assesses short- to long-run fiscal risks based on 10 indicators centred on three areas: i) financial markets; ii) debt structures; and iii) debt dynamics and sustainability pressures.

Structural factors such as debt profile and debt dynamics are stronger for most AEs compared to EMEs

Looking beyond immediate financial-market indicators, which can change quickly, structural factors such as a sovereign borrower’s debt profile and debt dynamics are stronger for most AEs compared to EMEs.

As a result, safe and diversified investor bases and a stronger revenue mobilisation capacity of AEs compared to EMEs allow the former group to carry higher debt burdens and fund large stimulus packages with limited immediate pressure on their credit ratings as compared with EMEs.

Still, in the longer run, pressure is also rising for advanced economies unable to grow out of their debt burdens or raise additional tax income, exacerbated by demographic pressures.

De facto fiscal space is a useful indicator to assessing a sovereign’s capacity to service debt

The implied de facto fiscal space – the ratio of outstanding public debt to realised government revenue – is a useful indicator to assessing a sovereign’s capacity to service its debt and fund stimulus via an existing tax base.

The time it would take to pay back public debt is particularly concerning for Japan (7.3 years), the US (4.1), Greece (3.8) and Italy (3.1), which reflects their elevated public debt stocks.

For the US (4 years) and China (3.0 years), a combination of high public debt and relatively modest tax revenue (of around 30% of GDP) explain the lengthy time it would require them to pay back debt compared with the average of about 2.0-2.5 years for a full 48 sampled economies in our analysis.

Years to repay debt, selected advanced, emerging economies, 2022-26

However, a crucial factor is the room and capacity governments still have for raising taxes should they need to. The position of the US contrasts positively with some AEs with already elevated levels of tax revenue to GDP, including France (51%), Belgium (50%) and, to a lesser extent, the United Kingdom (37%).

Some highly indebted advanced economies face increasing fiscal pressure

Highly indebted AEs with already high tax revenues relative to GDP and low growth prospects are likely to face increasing fiscal pressures over coming years.

Scandinavian countries as well as central and eastern European countries such as Latvia, Lithuania and Bulgaria benefit from significant fiscal space according to this metric, as they would need less than a year of tax revenue to fully pay off public debt.

The Fed raising rates will put rising pressure on emerging economies

Conversely, emerging economies, on average, are less indebted but generate lower revenue relative to GDP, reflecting constrained revenue mobilisation due to less sophisticated fiscal systems and more significant informal economies. Some emerging economies are expected to face sharp increases in their interest payments, including South Africa (+8.5pps), Turkey (+6.2pps) and India (+4.9pps).

As the US Federal Reserve tightens interest rates further this year, this will put increasing pressure on emerging-market economies in the near to medium term, particularly those for which finances were stretched by this Covid-19 crisis.

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Thibault Vasse is Senior Analyst in Sovereign and Public Sector ratings at Scope Ratings GmbH. Alvise Lennkh, Executive Director at Scope Ratings, contributed to writing this commentary.