Increasing External Debt and Electoral Cycles in Emerging Markets: How Do They Affect Prospects for Long-Term Growth?

Recently, the World Bank published its latest Global Economic Prospects report (GEP), which highlights a welcomed cyclical recovery for all major regions of the world following recent slow growth. I was pleased to participate in a panel discussion at CGD analyzing the report’s findings, and to share my perspectives both on its implications and on future global outlooks—­­especially for emerging market and developing economies (EMDEs).

Although short-term growth prospects have improved for EMDEs, with an expected average of 4.5 percent for 2018 and 4.7 percent for 2019 and 2020, the report stresses that this is no time for complacency. Despite improving economic activity, potential long-term growth is predicted to extend its decade-long falling trend in these economies. Undoubtedly, this impedes the likelihood of any foreseeable convergence of per capita income with those of advanced economies. So then, what should policymakers in EMDEs do? The answer is straightforward: they should implement proper reforms to improve potential growth. As the GEP report emphasizes, the right policies should aim to boost human and physical capital and improve productivity through reforms in infrastructure, education, health systems, labor markets, governance, and business climate.

The question then becomes, how likely is it that these necessary reforms—to improve productivity and convergence prospects—will materialize? The answer depends on two factors: the capacity and the willingness of policymakers to pursue proper reforms.

Many reforms inevitably require large financing capacities. This is often the case, for instance, with infrastructure investments. Yet, one does not need to look further than the IMF’s latest World Economic Outlook to recognize the vastly limited fiscal space amongst EMDEs, especially commodity exporters. Consequently, policymakers from many EMDEs are taking advantage of the currently favorable conditions in international capital markets, which continue to offer attractively low interest rates. This outcome is supported by little risk differentiation among EMDEs’ debt by investors, as reflected by very low spreads (the difference in yield between EMDE bonds and US Treasury bonds of a similar maturity). This points to an underpricing of risks.

The Latin American Committee on Macroeconomic and Financial Issues (CLAAF), over which I preside, explored this underpriced risk phenomenon in our most recent statement. We noted the resounding success that EMDE nations—even those with low credit ratings—have had in issuing international bonds. This was the case both with Côte d’Ivoire, which successfully sold bonds internationally during a military riot, and with Iraq, which issued a bond with demand that far exceeded what was offered, to name a few. This growing debt accumulation is alarming as there are many external risk factors (as noted in the GEP report) that can increase both the costs of servicing this debt and the likelihood of defaults. Therefore, for the rise in debt levels to be justified, they must be accompanied by a willingness on the part of EMDEs’ policymakers to pursue reforms that will lead to future growth—a necessity to amortize these liabilities and avoid potential crises.   

Although there are numerous reforms where funding is not the binding constraint—labor market reform being a point in case—all reforms are bound by policymakers’ willingness to pursue them. This is the part of the story that meets the reality of the current political economy in many EMDEs. 

In many EMDEs, there is growing resentment towards democracy. Recent data from Afrobarometer depicts a slowdown in the demand for democracy in Africa since 2008, with 24 of the 36 countries surveyed experiencing negative or neutral changes. Similarly, surveys by the Latin American Public Opinion Project at Vanderbilt University show that support for democracy in Latin America has dwindled from 66.4 percent in 2014 to 57.8 percent in 2016/17. This trend is supported by a frustrated new middle class in EMDEs, who experienced a significant increase in their standards of living until recent years. According to a poll by Latinobarómetro, 37 percent of people in Latin America self-identified as belonging to the middle class in 2011, and this value rose to 42 percent in 2017. Surely this middle class feels more entitled as they have seen solid gains in their consumption and societal status, which they wish to continue experiencing and will not be willing to give up. A similar picture can be painted for the middle class in many other EMDEs.

As noted by Daniel Zovatto, in Latin America, this middle class discontent is materializing as we approach a marathon of important presidential elections. This heavy election cycle appears to be a common occurrence amongst EMDEs. For example, there are 12 Latin American presidential elections in the next two years and 14 African elections (general or parliamentary) in 2018 alone. This creates a good moment to propel populist political candidates to power who promise to secure the improved lifestyles of the middle class, which they strongly fear losing. If this were to materialize, the easily accessible external funding available to policymakers would likely be used to meet the demands of this vulnerable middle class through short-term benefits—not long-term productivity investments.

A great risk facing EMDEs is that although external funding conditions are favorable, the current domestic political economy suppresses the incentives for proper reform. The outcome then could be a major debt problem. Let’s hope that citizens of EMDEs choose the right leadership to put in place the proper reforms to increase the much-needed potential growth.