Should we be concerned about rising fiscal deficits in emerging markets?

Most major emerging markets (EMs) are running sizeable fiscal deficits regardless of GDP growth, inflation, or interest rate levels. Such conditions have often been associated with financial distress or crisis. But the specifics of funding flows for many major EMs suggest those governments should be able to avoid fiscal crisis this time. 

Although sizeable, these deficits are within the range of the last three decades, including the significant deficits during COVID and the Global Financial Crisis. That said, in the early 2000s, many countries experienced high growth and were emerging from financial crises which resulted in tighter budgets and smaller deficits.

As a result, public debt to GDP ratios are rising in many countries, notably in China and South Africa. Debt ratios in India and Brazil are high but have been declining with high nominal GDP growth. Turkey has managed to keep its debt ratio falling despite a large cyclically-adjusted fiscal deficit through high inflation and very high nominal GDP growth – an effective but unsustainable approach that has led to political and financial instability. 

China

We see little risk of a fiscal or financial crisis in China, despite high fiscal deficits and debt ratios. Rather, the risk is one of lower growth, reflecting the rising debt burden and aging population and reluctance to stimulate growth through additional borrowing. Credit issues and NPLs may increase, but domestic savings, at around 50% of GDP¹, which are mostly held in the state-near financial and banking sectors, could absorb losses and help with refinancing. Capital controls and macroprudential restraints on the private financial sector should also reduce the risks of a crisis.

India

India’s high deficits and debt ratios are concerning but should continue to be fully financed in our view. Historically, there have been few fiscal crises in independent India because of elements of financial repression. Banks must hold government bonds. Heavy domestical use of Indian rupee enables the Reserve Bank (RBI) to transfer sizeable seigniorage (difference between the face value of money and its production costs), FX and bond valuation revenues to the federal government. And although India has often run significant fiscal and current account deficits, budget financing is largely domestic with a mix of foreign direct investment and equity portfolio inflows for the current account. Bond index inclusion could spur inflows into government bonds that lower interest costs and increase fiscal headroom and the risk of destabilizing outflows when global or domestic conditions deteriorate.

South Africa

South Africa requires monitoring, due to slow growth, high unemployment and operational difficulties for businesses. It is to be hoped that the new government will pursue reforms that could boost growth and employment. Fiscal performance would likely improve in a virtuous circle over time.

Brazil

Brazil deserves close focus, given its prolonged high inflation due to monetary policy being subordinated to political goals instead of financial stability. The independence of the central bank has been a bulwark, but occasional challenges to these institutions elevate the risks. Indeed, Brazil’s high real policy rates and bond yields suggest that investors are demanding a larger risk premium.

Investment Implications

Our institutional investor exposure is skewed to active China exposure in stocks and bonds. More generally, we prefer EM fixed income for active exposure and EM ex-China equity for passive exposure. China home bias is likely to persist given the market size and geopolitics and similar profile is expected to emerge in India.

On the other hand, institutional exposure to smaller EM economies is likely to be driven by a combination of domestic policy choices and global economic cycle. Strategic allocations would emerge if/when other major EMs (Brazil, Argentina, Mexico, South Africa, Nigeria, Turkey) shift their economies from global drivers such as commodity, manufactured goods or investment cycle to domestic demand. Until then, we would expect cyclical exposures to prevail.  

Investment risks

The value of investments and any income will fluctuate (this may partly be the result of exchange rate fluctuations) and investors may not get back the full amount invested.

When investing in less developed countries, you should be prepared to accept significantly large fluctuations in value.

Investment in certain securities listed in China can involve significant regulatory constraints that may affect liquidity and/or investment performance.