Enhancing Debt Resilience in Emerging Economies

Unexpected surges in debt can impede economic growth and trigger inflation in emerging economies. Strategies such as fiscal frameworks, strategic debt consolidation, and policy coordination are crucial in addressing these issues and strengthening economic resilience.

The global financial crisis from 2007 to 2008 led to a significant rise in debt accumulation in emerging market economies due to lower global interest rates, which reduced the cost of sovereign borrowing. This trend continued as the need for fiscal stimulus in response to the COVID-19 pandemic further increased debt levels. In 2022 and 2023, high inflation post-pandemic led to a tightening of global monetary policy, raising concerns about debt sustainability due to high debt levels and increased debt servicing costs.

Although inflationary pressures have been easing throughout 2024, partly due to the delayed effects of tight monetary policy and a decrease in global commodity prices, the US Federal Reserve's 50 basis point rate cut in September provided some relief for emerging economies looking to start their monetary policy easing cycles.

However, the robust US labor market and stronger economic activity suggest that the Fed's easing pace might be slower in the future. This is further complicated by the potential inflationary effects of policies proposed by US President-elect Donald Trump on trade, immigration, and tax.

Fed rate futures indicate a reduced expectation of cuts, forecasting only 75 basis points by October 2025, down from 125 basis points before the election on 5 November.

While some interest rate reduction is anticipated, which could alleviate debt servicing burdens in emerging markets, rates are expected to remain higher than in the 2010s.

A recent ADB Economics Working Paper and journal article analyze the impact of unexpected increases in debt on output and inflation in 34 emerging market economies from 2000 to 2022, highlighting significant challenges for policymakers.

Previous studies suggest that debt levels exceeding 90% of GDP can negatively affect growth, and persistent fiscal deficits and high debt can limit the central bank's ability to tighten monetary policy, leading to higher inflation expectations.

Our research shows that real GDP significantly decreases following an unexpected increase in public debt, while inflation reacts in the opposite direction. Specifically, a 1% positive public debt shock results in a maximum real GDP decrease of –0.015% approximately two years post-shock.

Conversely, an unexpected rise in public debt is linked to a sustained increase in inflation about one year after the shock.

Our study also investigates domestic economic fundamentals that could influence these outcomes. Higher initial debt levels, tighter domestic financial conditions, and lower income levels exacerbate the effects, particularly on GDP. Emerging market economies also experience more severe impacts during recessions.

Policymakers aiming to enhance public debt sustainability should prioritize long-term fiscal consolidation strategies, as lower initial debt levels or a declining debt trajectory can lessen the negative impact of debt shocks on growth. Building fiscal buffers during prosperous times can be a significant factor.

Policymakers should consider the output and inflation effects of unexpected debt shocks when designing medium-term fiscal frameworks, especially given the severity with high and increasing debt.

In this context, national fiscal authorities must establish credibility in macroeconomic projections and maintain a well-anchored fiscal path. Fiscal rules can support public debt management and macroeconomic resilience. Monetary and fiscal policies should be well-coordinated.

Incorporating risk factors into fiscal frameworks can mitigate the effects of debt shocks on the economy, reducing debt sustainability exposure and creating policy space for shock responses.

Furthermore, emerging market economies should focus on policies for long-term sustainable growth, as higher income levels enhance resilience to debt shocks for both growth and inflation. Increasing tax revenue and mobilizing domestic financial resources, including by broadening the tax base, will be crucial.