Investments 101: Emerging Markets: Debt Still Rising
Emerging markets had a banner year in 2017. The last six months has treated them less kindly.
Can superior economic growth overcome rising debt in emerging markets?
Emerging markets have stumbled thus far in 2018 after enjoying solid appreciation in 2017.
Stated economic growth in places like China and India remains well above that of developed economies. Financial markets appreciated that fact and propelled emerging markets to a gain of over 45% in 2017.
However, 2018 has been a rockier story for emerging markets. Nearly six months after the solid rally in 2017, emerging markets have declined roughly -4%.
Several reasons include fears of capital outflows following the US Federal Reserve’s intentions to keep raising interest rates in 2018. Threats of further tariffs by the US on China also have caused concerns over deterioration in emerging market growth rates. Political unrest in Brazil has also weighed on sentiment.
However, the biggest potential overhang to emerging markets might be debt.
Emerging Market Debt Rising with Growth – What Gives?
The chart above compares total government debt in emerging markets vs. developed economies.
Moody’s, a global debt rating agency, tracks the level of national debt (akin to Treasury bonds in the US) relative to Gross Domestic Product (the level of economic output for a given country). Averages are then computed for both emerging markets (the light blue bars) vs. developed (the dark bars).
A couple of trends bear watching:
- Emerging markets have lower debt to GDP than developed markets. This trend has been in place since 2007, the eve of the Global Financial Crisis. There is a big “but”.
- But emerging market levels have closed the gap with developed markets. While developed markets witnessed a decline in debt since the peak in 2013, emerging markets have actually grown consistently since 2007. The gap has narrowed from roughly 30% in 2013 to only 10% in 2018. This is notable given the gap in interest costs emerging markets pay relative to developed markets.
A growing debt to GDP ratio implies that economic growth is dependent upon debt issuance.
Debt issuance, particularly in emerging markets, can be a fickle source of funding growth. Flows of capital into emerging market debt has been historically volatile. Interest rates can rise sharply if foreign outflows were to occur. Because the size of emerging market debt markets is much smaller and less liquid than in developed markets, interest rates can spike more sharply if investors were to pull out capital. Spikes in interest rates can depress future economic growth.
Developed countries in Europe and the US were most affected by the 2008 Financial Crisis.
In efforts to prop up their economies and save their banking systems, central banks and governments collaborated to inject money into their economies. Consequently, many developed countries suffered from rising debt to GDP levels. As economic growth has returned, debt to GDP has started to decline.
In contrast, debt to GDP in emerging markets has risen despite economic growth.
One factor is China, where fiscal deficits and other stimulus attempted to prop up high growth rates. The question exists as to when and how much will growth in China slow. China cannot continue its rate of debt expansion. Other economies in Asia and Latin America also experienced growth in fiscal spending and domestic credit expansions. The idea was this stimulus would offset declining growth in world trade. Unfortunately, emerging markets might now have entered a phase where they have less ammunition to confront a global environment of rising interest rates and positive, but not spectacular, global growth.
Growth and interest rates are the key factors to watch for emerging markets.
Let us help your family to navigate through this challenging environment.
 For a definition, see Kimberly Amadeo, “What Are Emerging Markets? Five Defining Characteristics”, March 22, 2018, the balance on https://www.thebalance.com/what-are-emerging-markets-3305927 accessed on June 18, 2018.
 As measured by the return in the iShares Core Emerging Markets ETF (symbol: IEMG).