Strengthening Financial Stability in Developing Economies

Sudden increases in debt can hinder economic development and cause inflation in developing economies. Key strategies such as fiscal structures, strategic debt management, and policy alignment are essential for tackling these challenges and bolstering economic strength.

The 2007-2008 global financial crisis resulted in a considerable surge in debt in emerging economies due to reduced global interest rates, which lowered the cost of sovereign debt. This pattern persisted as the need for fiscal stimulus in response to COVID-19 further escalated debt levels. In 2022 and 2023, elevated inflation post-pandemic led to a contraction in global monetary policy, raising concerns about the sustainability of debt due to elevated debt levels and increased servicing costs.

Although inflationary pressures have been diminishing throughout 2024, partly due to the delayed impact of tight monetary policy and a reduction in global commodity prices, the US Federal Reserve's 50 basis point rate reduction in September offered some relief for emerging economies considering the start of 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 diminished expectation of cuts, forecasting only 75 basis points by October 2025, down from 125 basis points prior to the election on 5 November.

While some interest rate reduction is expected, which could alleviate the burden of debt servicing in emerging markets, rates are anticipated 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, underlining significant challenges for policymakers.

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

Our research indicates that real GDP significantly decreases following an unexpected increase in public debt, while inflation responds 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 associated with a sustained increase in inflation about one year after the shock.

Our study also examines 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 focus on long-term fiscal consolidation strategies, as lower initial debt levels or a declining debt trajectory can reduce the negative impact of debt shocks on growth. Building fiscal buffers during prosperous times can be a significant factor.

Policymakers should take into account 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 concentrate 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.