In our previous paper on the impact of rapidly growing budget deficits in Japan, Western Europe and the US, we examined the relationship between debt levels and the short and long-term interest rates over time for 12 developed economies. Generally, the higher debt levels rise, the further interest rates tend to fall. This makes debt markets unique: the larger the supply, the higher the price and lower the yield (price and yield move inversely). What sets debt markets apart are central banks, which set short-term rates knowing that extremely high debt burdens can only be sustained with ultra-low policy rates. At the longer end of the yield curve, investors in highly indebted countries appear to accept that short-term rates will mostly likely remain low for a long time.
In most emerging markets, there is a very different narrative at play. With a few exceptions, like China and Poland, emerging market nations tend to have much lower levels of debt (Figure 1). And, in China, high levels of debt are a relatively recent feature (Figure 2). In the least indebted emerging markets, such as Mexico and Russia, the total debt-to-GDP ratio is around 80%. That is less than one third the level in the US, Canada, Eurozone and UK, and less than one quarter of Japan’s. That said, most emerging markets, China aside, have experienced a trend toward rising levels of debt over the past decade, especially since the financial crisis in 2008. If this continues, they may slowly come to resemble their developed-nation peers.
What sets emerging markets apart in 2020 isn’t just the levels of debt but their near-term trajectory. France, Germany, Italy, Japan, Spain, the UK and US have announced stimulus/relief recovery legislation that could easily push budget deficits in those nations into the 20-30% of GDP range in the next year. By contrast, nations like China, India, Mexico and Russia have so far announced stimulus packages amounting to around 1% of GDP.
In contrast with highly indebted developed markets, which show a strong negative correlation between rising debt and falling short and long-term interest rates over time (Figure 3), the connection between debt levels and interest rates in most emerging markets is much more tenuous, although it’s still negative for seven of the nine markets (Figure 4). The two countries where the correlation between debt and interest rates levels has been positive over the past two decades -- South Africa and Russia -- exhibit the lowest debt levels.
Put another way, the more debt a country has accumulated, on average, over the past two decades, the more reactive its central bank and long-term bond investors are to those debt levels (Figures 5 and 6).
Not surprisingly, there is a strong inverse correlation between recent levels of long-term interest rates (averaged over mid-March to mid-April) and the total level of debt (public + private).
Investors in highly indebted nations/currencies don’t appear to believe that their central banks have set interest low temporarily to deal with a short-term crisis. Judging by the level of long-term rates, investors assume that short-term interest rates will stay low for many years because central banks, faced with such large debt burdens, have little choice other than to leave rates low.
By contrast, investors in low-debt emerging markets take a different view. Long-term bond yields in these nations suggest that investors see central bank rate cuts as being temporary. For the most part, these countries are not engaging in a great deal of fiscal easing, so debt burdens might not grow much.
And these countries have other means of defending themselves economically against the COVID-19 downturn. Rather than issuing debt to ramp up spending, they can allow their currencies to fall, insulating themselves against the consequences of weaker export prices (see our article here).
If the debt burdens rise in countries that are already highly indebted while remaining low in the least indebted nations, it could widen an already large divide between high-interest rate/low-debt emerging markets and high-debt/ultra-low interest rate developed nations.
Amid this divide, China finds itself in the middle. Unlike Japan, Western Europe or the US, it has so far refrained from extensive fiscal measures. Its central bank has cut interest rates but not as dramatically as the Federal Reserve. The People’s Bank of China hasn’t gone to zero rates. Moreover, its currency has been largely stable even as most other emerging market currencies have plunged. Domestically, it’s getting back to work, having shut down its economy two months before most other nations. Even so, life in China may not return to normal pace quickly, and demand for its exports will likely be extremely weak for months to come.
As such, at some point, China might opt for some combination of additional fiscal stimulus, further monetary easing or a weaker currency. In the past, the renminbi has often followed, rather than lead, other emerging market currencies lower (Figures 8 and 9).
Currency devaluation is relatively easy for smaller economies and more of a challenge for the biggest. Essentially, only one or two of the biggest economies can have a weak currency at a time: the US from 2002 to 2011; the EU from 2011-2015; Japan from 2013 to 2015; and the UK from 2016 onward. They can’t all weaken their currencies simultaneously against other fiat currencies – although they can all fall against real assets, like gold. For the moment, however, the reserve currencies – the US dollar, euro, Swiss franc and yen -- have been relatively strong against the commodity exporting currencies. Here too China’s currency is behaving like a developed market. The renminbi is holding its own versus the US dollar, the euro and the yen and soaring against most others. Moreover, China cannot allow for a dramatic devaluation of its currency without sending shockwaves through global markets, as the world discovered in August 2015. If the renminbi is devalued, it’s likely to be a slow, progressive process, gradually catching up with other emerging market currencies on the downside.
If interest rates were to fall in any emerging market, it might be in Brazil, where debt is climbing faster than in most other emerging market countries, and where fiscal stimulus might add more to budget deficits than appears likely in India, Mexico and Russia.
All examples in this report are hypothetical interpretations of situations and are used for explanation purposes only. The views in this report reflect solely those of the author(s) and not necessarily those of CME Group or its affiliated institutions. This report and the information herein should not be considered investment advice or the results of actual market experience.
Erik Norland is Executive Director and Senior Economist of CME Group. He is responsible for generating economic analysis on global financial markets by identifying emerging trends, evaluating economic factors and forecasting their impact on CME Group and the company’s business strategy, and upon those who trade in its various markets. He is also one of CME Group’s spokespeople on global economic, financial and geopolitical conditions.
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