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• The Politics of Debt in the Era of Rising Rates

Transcript

Tim Sablik: My guest today is Marina Azzimonti, a senior economist and research advisor at the Richmond Fed. Marina, welcome back to the show.

Marina Azzimonti: Thanks for having me. It's great to be here again.

Sablik: Today, we're going to be discussing a recent working paper that you wrote with Nirvana Mitra of CAFRAL. In it, you examine how changing global interest rates interact with the political environment in emerging market countries to influence the accumulation of national debt. You focus on the 2020s, which saw dramatic shifts in interest rates during and after the COVID-19 pandemic.

I'm sure many of our listeners are familiar with what happened to interest rates in the United States, but can you give us a sense of what happened to the cost of borrowing globally over the last few years?

Azzimonti: Let me start by clarifying what we refer to as the cost of borrowing.

Very much like households, governments issue debt — in this case, known as sovereign debt — to finance their expenditures that go above and beyond their revenues. The cost of borrowing is the interest rate that they need to pay on these loans, very much like a consumer does.

Similar to what happens to consumers who may have to pay different borrowing rates depending on their credit history or their income, countries pay different rates depending on their characteristics. In this case, it would be the health of the economy — are they in a boom or in a recession? — the soundness of their public finances, and their likelihood of default, which is a very important aspect for lenders.

So, when you think of the cost of borrowing, we need to specify which type of country we are thinking of. The governments of developed countries like Germany, Japan, the U.S., and the U.K. borrow at what is known as the "risk-free rate." Risk-free means that markets expect these countries to repay, so their probability of default is zero. The cost of borrowing for these countries is the cheapest because they have no risk. The cost of borrowing for other countries is typically higher because, in addition to the risk-free rate, they pay what is known as a spread — what investors need to be compensated because they are incurring these default risks in the future.

Now, let me go back to your actual question, which is "what happened to the cost of borrowing?" We faced very significant changes in the last few years. During the 2020s when we were facing the COVID-19 pandemic, risk-free rates were at a historical low. They were basically zero percent. Central banks in advanced economies reduced the rates because they wanted to stimulate economic activity and they wanted to stabilize financial markets.

However, when the global economy began recovering, when we started getting out of the pandemic and inflation pressures started to mount, central banks shifted course. Between the first quarter of 2022, where these rates were basically zero, and the end of that year, rates rose very sharply to about five percent. This shift, while necessary for macroeconomic stability, increased borrowing costs globally. Countries that had significant debt burdens had a need to come up with new resources in a very short amount of time.

Sablik: You mentioned these big swings in interest rates over the last few years, and part of the reason for the low rates during the pandemic was as a stimulative measure. What happened to national debt levels during this period?

Azzimonti: During the pandemic, governments worldwide — including those in emerging markets — borrowed heavily. They needed this to fund relief measures quickly to stabilize the economy, to stimulate the economy, or to pay other costs. This surge in borrowing in emerging countries was not only driven by the need to respond to the crisis, but also because it was very cheap to borrow. As a result, many countries took advantage of the favorable conditions to finance additional spending above and beyond pandemic-related spending needs.

By 2022, the debt-to-GDP ratios in most emerging economies were significantly higher. For example, if we look at Mexico, their historical average between 1990 and 2022 was about 30 percent debt to GDP. It grew to 50 percent. If you look at Argentina, historical was 60 percent and they went to 90 percent. Some countries even surpassed 100 percent debt to GDP. So, as global interest rates began to rise, this raised critical questions about how sustainable these debt levels were and whether the higher rates would lead to a wave of defaults in these countries.

Sablik: Right. So, as global interest rates rose starting in 2022, the cost of borrowing new debt but also servicing this existing debt went up. Why does this pose a particular challenge for emerging market economies?

Azzimonti: Emerging markets face several structural challenges that amplify the impact of these rising rates.

Many of them rely heavily on foreign capital. When rates were low, a lot of the foreign capital was willing to take a risk [in] an emerging market, both in terms of borrowing their sovereign debt but also on financing industries within that country. When you get the safer alternative that pays better, like risk-free rates, some investors felt that this was less appealing. So, countries that rely heavily on foreign capital tend to see this capital quickly flee when global interest rates rise. This leads to tighter financial conditions in these countries. It's more difficult to get funds.

This may depreciate their currencies. This is a big deal because many, if not most, emerging economies have their sovereign debt denominated in foreign currencies, typically in dollars. So, when your currency depreciates, that five percent debt to GDP becomes more excruciating because, in terms of your own currency, it can be a lot of money.

Sablik: How do politics and institutions in emerging markets influence the accumulation of national debt?

Azzimonti: Let me start with what we know from the data.

Institutional strength — checks and balances, democratic representation, accountability of politicians, control of corruption — is negatively related to these sovereign spreads. Countries that have stronger institutions can borrow at cheaper rates. This is because their governments are perceived as more credible, as more likely to pay.

Another piece that we learn from the data is countries with strong institutions — and these are typically the developed ones — manage recessions very differently than emerging markets. They behave very much like what any economic theory would predict. You have a recession, you borrow because you do not want to increase taxes when times are bad, and you want to use that money that you borrowed to stimulate the economy or to face something like a war or a natural disaster. When things get better, when they go back to normal, they try to repay the debt or at least not borrow as much. This is the typical dynamics.

What do emerging markets do? They do exactly the opposite to what economic theory would say. They borrow when their economies are experiencing a boom because this is when international investors are more excited on betting on countries. Those emerging markets that have weak institutions tend to spend these extra resources "discretionarily," if that is a word. They do discretionary spending. They don't try to invest or fix their institutions or improve their finances. They split the pie.

So, when a recession hits, they have a ton of debt. They don't have a lot of space to borrow. Basically, when a recession hits, they default a lot of the times. They don't prepare for rainy days that developed countries typically do.

Our theory explains this relationship between institutional strength and spreads through the political dynamics in emerging markets. In emerging markets, in order to govern, a politician typically needs to form coalitions. These don't always take the same form as in developed economies. They are not typically political parties that need to form a coalition. Sometimes they are less conventional. So, in order to implement a proposal, a politician needs the support of an oligarch or a group of oligarchs, or a religious group or an ethnic group, or a powerful interest group with a big lobby.

How does the government secure the support of a minimum [number] of groups? Well, they typically allocate part of the budget to political favors, devote some of their spending on the objectives of these specific groups so that they can maintain their support. At the same time, politicians can divert resources to their own constituents for personal gain.

These dynamics and this lack of checks and balances and independence of the executive, legislative and judiciary powers make the potential for misuse of public funds pretty high. It's very tempting for politicians to borrow in order to fund these expenditures because then they don't need to increase taxes. This creates an inherent incentive to overborrow, particularly in periods of low global interest rates. So, if it's very cheap, then it's very tempting to borrow to secure the support of these groups.

When the economy recovers, as it did following the pandemic, what do these emerging markets typically do? Instead of implementing austerity measures or saving for future downturns, politicians prioritize short-term political gains. So, when the conditions worsen or interest rates rise, the accumulated debt becomes unsustainable. Because these countries typically choose not to have reserves or fiscal buffers, they are more likely to default.

In contrast, countries with stronger institutions [and] robust checks and balances find it more difficult to engage in this type of behavior. In these developed countries, there is more of what is known as horizontal accountability. You need, typically, to change laws [in order] to change particular spending levels.

Sablik: Once an emerging market has accumulated debt in a low-interest period, what options does it have for responding to a sudden increase in borrowing costs?

Azzimonti: The options for emerging markets are limited and often painful.

Let's go back to the example I gave at the beginning of a country which owes 100 percent of their yearly production — their debt-to-GDP ratio is 100 percent. When a rate goes from zero to five percent, that country needs to come up with five percent of yearly production just to pay interest.

What option does the government have in that case? There are basically three routes you can take. One is to adopt an austerity measure — we need to reduce spending or increase taxes. But these typically come with significant economic and social costs. People may protest and then the government needs to step down. This happens a lot in emerging markets.

Another option is to default. This will temporarily alleviate the fiscal pressure. You don't need to come up with five percent of GDP anymore. But it's going to damage the reputation and it's going to make it more difficult to access international markets in the future. So, if you get into a recession next year, then you're in trouble.

The third option is that they can turn to an international financial institution like the IMF for assistance.

Sablik: Your paper focuses particularly on that last option: borrowing from an international financial institution. As you mentioned, one of those types of institutions is the International Monetary Fund or IMF, which was established, in part, for just such a purpose: to lend to countries in crises. But in your paper, you find that borrowing from these institutions can potentially worsen sovereign debt crises. How?

Azzimonti: Our research shows that, while international financial institutions' loans provide short-term relief, they can unintentionally create what is known as moral hazard. Policymakers may view this loan as an easy exit. [That] can reduce their incentives to implement prudent fiscal policies even further. If you have this outside option that lends you money even when you're in default, then you might find it even more attractive to borrow and more attractive to default.

Without proper safeguards, these loans might fund corruption or inefficient spending. This can exacerbate the country's long-term fiscal challenges, potentially trapping them in cycles of borrowing and default.

The IMF obviously understands this. So, whenever they make a loan to an emerging market, they attach conditionality rules to it. Some of these are known as quantitative performance criteria. For example, they can attach an upper bound on how much you can spend [or] on how much you can borrow; this is known as a debt ceiling. They can ask you to implement an austerity measure, they can ask you for more transparency in the way in which you do finances, etc.

What we did in our analysis is conduct a counterfactual experiment to understand what would happen if these loans were not subject to these rules. What we found is that, absent conditionality rules, the likelihood of overborrowing and misuse of funds increases a lot. This can further perpetuate a soaring debt crisis.

Sablik: Let's dig into that a little bit more. Can you give some examples of the types of conditionality rules that international financial institutions can do that help reduce risk of default after making these loans to countries experiencing a debt crisis?

Azzimonti: The IMF has a series of conditions that can be attached to loans that it makes to emerging countries. These conditions are going to vary on the particular countries, so where does the IMF officials feel the country needs to improve in order to make the likelihood of the repayment the highest possible. There is sort of a bargaining between IMF officials and the government of a country to agree on the amount that is going to be lent, the terms of the loan in terms of interest rates, and what are these conditions that are going to be attached to the loans.

Some of them are structural reforms. Structural reforms typically need changes in the law, for example, a change in your social security system — going to a private security system versus a nationalized social security — or imposing a borrowing limit in the constitution.

There are other reforms that are called quantitative performance criteria that are easily measurable, and they are things that already exist in a country but where the IMF requires the country to meet a certain number. For example, you need to reduce your discretionary spending by five percent, or you need to reduce your borrowing from the private sector by this much over this period of time.

In our paper, we consider two of them: a debt ceiling paired with an austerity measure. This is one of the most standard approaches taken when the IMF gives loans. They are pretty effective. In our model, we find that that can significantly reduce the risk of default because it can undo this desire of politicians of borrowing to fund discretionary spending. If you don't let them borrow from outside, then they don't have that many resources to misuse.

But, of course, there are costs because they also have less incentives to fund education and other public goods that are very beneficial for society. Moreover, they may choose not to cut discretionary spending that they need for their own purposes, and they can instead cut spending that is good for society — educating the workforce, defense, keeping the water safe, etc.

Another conditionality rule that we analyze in this paper is something that attaches the loan to the obligation of implementing anti-corruption efforts. At an extreme, you could tell a country, "Okay, I give you the money, but you cannot use it to give these political favors." If we could perfectly monitor that, we find that it's also going to reduce the risk of default. It will reduce it by much more than a debt ceiling rule because it's tackling the root of the problem, which is the desire of these politicians to misuse the funds. You are going to generate much better outcomes, both for society and for international investors.

Now you might come and say, "Well, it's very difficult to discover whether a country is using or misusing funds." Some politicians go great lengths to hide corruption spending. Well, one thing you could do is you could monitor randomly. Let's say you only catch five percent of the misuse. Even with the small monitoring of corruption and a small punishment if you discover corruption, you can have very beneficial effects, almost as much as the debt ceiling rule that I mentioned before.

Sablik: Very interesting. Thanks for that explanation. As you said, it's the anti-corruption measures — you find them to be more effective, but the monitoring of those is the real challenge.

Marina, thank you so much for joining me today to discuss your work.