Fiscal incontinence is going global and could pose a risk to financial stability

Ahead of his conversation with LBS’s Elias Papaioannou in the upcoming Geopolitics & Business Conference, David Lubin Michael Klein Senior Research Fellow, Global Economy and Finance Programme at Chatham House has written a compelling article on how public debt levels in emerging markets are rising at an alarming rate.

As the world’s finance officials head to Washington this week for the IMF and World Bank spring meetings, they are likely to be in a rather buoyant mood. The global economy – in broad terms – shows signs of surprisingly strong growth, while inflationary pressures continue to fall, notwithstanding recent jitters about price pressures in the US.

But what is the true cost of this robust growth? One answer is the apparently endless rise in the level of public debt.

The world has become familiar with the idea that US political system now has no mechanism to generate budget restraint: Republicans will cut taxes, Democrats will raise spending, and the result will be persistent fiscal incontinence. US budget deficits averaged 5.8 per cent of GDP in 2022 and 2023, and the Congressional Budget Office estimates they will average 5.3 per cent through 2030. US public debt, now close to 100 per cent of GDP, can only keep rising.

What is less well-known is that fiscal incontinence seems to be going global. There is a growing list of governments among emerging markets in Latin America, central Europe and Asia whose instinct is to care less and less about rising public debt levels. Not all of this is a threat to financial stability, but risks are rising. Emerging economies, by definition, have less debt-carrying capacity than their richer peers.

Take Mexico, for example. This year’s budget deficit, 5.4 per cent of GDP, is the country’s largest since the late 1980s, dramatically ending President Andrés Manuel Lopez Obrador’s (AMLO) earlier commitment to fiscal conservatism. The fact that this is an election year in Mexico goes a long way to explain the expenditure boost, but AMLO’s likely successor, Claudia Sheinbaum, may find this a tough trend to reverse.

In Thailand, the government is in the process of fulfilling its election campaign commitment to hand out cash to some 50 million citizens through a digital wallet, with the aim of boosting neighbourhood spending. Even with some watering down of the initial plan, the scheme is likely to cost some 1.5 per cent of GDP, putting the public debt stock on a firmly rising path.

In Brazil, strong budget revenues are helping to moderate market concerns about the country’s public finances – but this is unlikely to last long. President Lula has made it clear that he feels no particular commitment to Brazil’s fiscal rules if they conflict with his spending priorities.

In Indonesia, President-elect Prabowo has raised the prospect of a significant increase in the government’s debt burden to complete the construction of a new capital city, increase defence spending and provide free school lunches. He apparently has ‘no problem’ letting Indonesia’s debt/GDP ratio rise to 50 per cent, from the current 39 per cent.

And central Europe is not immune. In Poland, the government is working on measures that will loosen the fiscal stance even though the budget deficit this year is already set to top 5.5 per cent of GDP. Budget deficits in Hungary, where the public debt burden is already rather high at 73 per cent of GDP, show no signs of moderation.

This trend is not coming out of the blue. Public debt burdens in emerging economies have been shifting upwards over the past decade, rising much faster than in advanced economies. IMF data for 2022 suggest the average public debt burden among advanced economies was 112 per cent of GDP, not much higher than it was in 2012 at 106 per cent. By contrast, the average public debt burden among emerging economies rose from 37 per cent to 65 per cent of GDP during the same period.

There are three reasons to be pessimistic about public debt levels among emerging economies.

One is the persistent weakness of global trade growth. A developing country facing meagre export prospects will tend to rely more on domestic spending – including public spending – to sustain income growth at home.

Second, there are growing claims on public resources to mitigate and adapt to climate change, and respond to a rising sense of geopolitical insecurity.

Finally, there may well be a ‘negative demonstration effect’ at work. Policymakers in emerging markets take their cues from the policy environment they see operating in wealthier countries. If the US is showing signs of persistent fiscal excess, it is not really a surprise if emerging economies follow suit, notwithstanding the fact that developing countries have less debt-carrying capacity.

Of course, not all emerging economies have lost a sense of fiscal rectitude. Chinese fiscal policy, for example, is famously stingy these days (albeit that the public debt burden is already very high). And India – another huge developing country with an already large public debt burden – is also exhibiting sensible fiscal policy.

Nor is it the case that all debt is bad. Although some economists have had their reputations burnt by suggesting there are easily definable thresholds above which debt really becomes a problem, the fact is that these thresholds probably do exist, albeit are difficult to identify in advance.

At a time when investors are looking pretty favourably on emerging markets, they might do well to pause and consider that as debt burdens in the developing world keep rising to a level found among richer countries, global financial risk is slowly rising too. To its credit, the IMF itself has expressed some concern about all this – but the warnings will need to get louder.

Without private sector growth rapid enough to generate additional tax revenues, countries are basically unable to meet their spending objectives without pushing the debt stock up. Raise tax rates, widen the tax net or spend less on low-priority areas – there are no easy answers.

This article has been reproduced with the kind permission of Chatham House and David Lubin, Michael Klein Senior Research Fellow, Global Economy and Finance Programme

Professor Elias Papaioannou will be holding a fireside chat with David Lubin to discuss the Rise of the Global South: How does the current economic growth and future potential of emerging economies impact the existing world order?

The Geopolitics & Business Conference is the flagship event of London Business School’s Geopolitics & Business Club and is support by The Economist, the Institute of Geoeconomics and the Wheeler Institute for Business and Development.

The event (13:00-19:00: Keynote & Panels; 19:00-21:00: Networking Reception) will take place at London Business School’s Sammy Ofer Centre on April 25, 2024 at London Business School. Tickets are available here