Financial integration has permitted emerging market economies as a group to borrow externally more than ever before. In nominal U.S. dollar terms, emerging market public external debt grew markedly over the 1990s and has grown even faster since 2000. It is the composition of external debt, however, that shows best how much market access has improved: while external debt to official creditors and banks has been declining, market-placed bond debt, which hinges much more on investor confidence than do bank loans, has grown rapidly and now makes up a larger share of these countries’ external debt than at any point in the past three decades.
Improved market access
Three sets of mutually reinforcing factors underlie the recent improvement in market access:
Improvedfundamentals. Many emerging markets have improved their fundamentals by pursuing sound macroeconomic policies, implementing structural reforms to improve incentives for savings and investment, and reducing distortions. Also, debt sustainability, when measured against GDP or exports, has improved despite the rise in nominal debts. Many countries have also restructured their debts to reduce their cost of external financing—for instance, by lengthening the maturity profile of debt and refinancing high-cost with lower-cost obligations, as well as by better managing investor relations. These improvements have contributed to a large number of ratings upgrades over the past four years, with several countries now in the investment-grade category.
Evolvingfinancialmarkets. In part reflecting emerging market economies’ improved fundamentals and their growing influence in the global economy, their investor base has broadened and deepened, with the emergence of dedicated investors, including mutual funds and hedge funds. Emerging market assets are increasingly being identified as a separate asset class, and institutional investors—particularly some of the largest pension funds in the major industrial economies—have begun to include them systematically in their portfolios. Both developments have led to an expectation of more stable future capital flows, lowering the riskiness of the asset class and making it more appealing.
Exceptionallybenignglobalfinancialenvironment. Over recent years, global interest rates have declined; yield spreads have narrowed; and commodity prices have remained high, boosting growth and fiscal revenues in the many net commodity exporters among emerging markets. In addition, the weakening of the U.S. dollar over 2002-04 is likely to have benefited those countries whose debts are denominated in dollars but whose export bases are broadly diversified. Because many commodities are denominated in U.S. dollars, however, the overall effect of a dollar decline may be ambiguous.
Better fiscal performance
An analysis of 40 of the largest emerging market economies in four regions shows that fiscal performance has benefited considerably from improved market access. While there are considerable cross-country variations, the analysis shows that the median (average) country in each of three regions—Africa and the Middle East, emerging Europe, and Latin America—saved an estimated 2 percent of GDP cumulatively in its fiscal balances from 2002 to 2005 compared with 2001—that is, before financial conditions became unusually favorable. The exception was Asia and the Pacific, where, because of lower outstanding official debts, cumulative fiscal savings stood at somewhat less than 1 percent of GDP.
What accounted for these savings? The chief impetus was low global interest rates—more specifically, the combined effect of lower rates on variable-rate debt and on newly issued fixed-rate debt. In contrast, annual savings from narrower spreads have so far remained small, although they are considerably larger in net present value terms.
Exchange rate movements have had more ambiguous effects: calculated over 2002-05, they reduced, on average, debt service in Africa and the Middle East and emerging Europe but increased it in Asia and the Pacific and Latin America. This somewhat surprising finding is explained by the fact that the U.S. dollar, despite its overall weakness during that period, has appreciated against a number of currencies in some of the countries analyzed.
Reversal of fortunes?
What would be the effect on emerging market economies’ fiscal positions if the financial environment were to become less benign? After all, global interest rates at the short end of the yield curve have risen significantly as U.S. monetary policy has been tightened, and global long-term rates could rise from their recent low level, particularly if growth remains buoyant, inflation concerns increase, and the U.S. dollar is subject to further downward pressure. In the past, higher long-term interest rates have, in turn, tended to be associated with wider spreads. And it is not clear that commodity prices and exchange rates vis-à-vis the U.S. dollar will remain as favorable for many emerging markets as in past years.
Simulating the impact of higher global interest rates, wider spreads, a weak U.S. dollar, and high commodity prices (compared with the 2001 benchmark) on the 40 emerging market economies’ fiscal performance suggests that, on average, their fiscal deficit in 2005 would have been as high as in 2001 (see chart). While some have achieved substantial improvements, others have seen a worsening. This suggests that the recent decline in the fiscal deficits of many of them reflects more the benign financial environment than an improvement in the countries’ underlying fiscal performance. And, if fiscal fundamentals have improved less than they appear, a reversal in external financial conditions could bring about a deterioration in many emerging market economies’ budgetary positions.
Furthermore, there is an added concern: that the most vulnerable countries could be hit hardest by a change in external conditions, because they tend to benefit most from a benign financial environment. This could be compounded by a disproportionate widening of spreads in some cases, given the empirical evidence that the narrowing of the yield spread has been driven at least as much by liquidity as by fundamentals.
In reality, the effects of a less benign global financial environment will depend on a variety of considerations. The effects of a rise in interest rates, for instance, may be ameliorated to some extent by valuation changes attendant on any further dollar depreciation, and the relationship between risk premiums and spreads may be different from the past, reflecting changes in investor perceptions of the long-run prospects of emerging market economies. In general, it makes a difference if rates rise primarily because of strong activity (which would support emerging market growth), supply-side constraints, or oil price-related inflation pressures. And, even if conditions were to deteriorate, many countries would be able, at least for some time, to reap benefits from the improvements they have made in their assetliability structure in recent years.
Locking in the benefits
Countries that have pursued good policies should be able to deal better with an adverse environment. Others, whose underlying vulnerabilities may even have increased and that have relied mainly on the benign external environment, could make better use of the environment to strengthen their policies.
Continued structural reforms could help countries lock in benign financing conditions more permanently. Investors are likely, for example, to reward steps that signal more prudent behavior, and countries that take such steps could expect a payoff in the form of relatively lower spreads, even if external economic conditions were to turn sour.
An analysis of the relationship among a broad measure of fiscal transparency, countries’ sovereign ratings, and spreads indicates that more transparent countries get better ratings and pay lower spreads, even after controlling for other factors. Implementing just 5 additional best-practice fiscal transparency measures of 20 that were identified (such as publishing contingent liabilities) could yield estimated savings on the order of ¼ of 1 percent of GDP, on average, for the countries examined.
It is clear that countries pursuing sound policies benefit the most from financial integration. This suggests that there can be a virtuous cycle of prudent policies helping to enhance integration without raising vulnerabilities and improved performance, which, in turn, is a spur for greater policy discipline.
Copies of IMF Working Paper No. 05/212, “Financial Globalization and Fiscal Performance in Emerging Markets,” by David Hauner and Manmohan S. Kumar, are available for $15.00 each from IMF Publication Services.