The covid-19 pandemic has impacted credit metrics of Emerging Markets economies severely. Fiscal deficits soared to more than 10% this year due to stimulus measures as well as lower government revenues. Gross public debt, already on a deteriorating trend, increased by about 10% this year and, according to IMF, could hit 65% of GDP next year. Not all countries are riding the same wave. Russia, for example, only has 19% of public debt and Indonesia 38.5%, whereas South Africa has 78.8%, India 89.3% and Brazil is exceeding 100%. Public debt ratios may also not reveal the true burden of debt as in some countries state-owned enterprises make up for a significant part of indebtedness (think of China or Mexico’s Pemex) and some countries may have substantial off-balance sheet liabilities (e.g. pensions, healthcare).

It is difficult to say how much debt is too much. This depends on many factors, including the diversity of the country’s economy, the quality of its products, the percentage of debt denominated in foreign currency, the percentage of debt owned by foreigners, the maturity schedule of debt repayments, the trends in current account balances and foreign direct investments, the credit-to-GDP gap, the level of FX reserves, the (prospective) financing costs, etc. However, it seems to us that EM countries that have public debt in excess of 60% to 70% of GDP (depending on how much is foreign currency denominated) have reason to worry and should ready a credible fiscal consolidation plan.

As an aside, it is surprising to see how few credit rating downgrades have been awarded in this period of extreme financial stress. Of the larger EM countries, only South Africa and Turkey got downgraded by either Moody’s or S&P or both. India and Mexico also received a downgrade but are somehow still considered to be investment grade. In advanced economies we did not see any downgrade even though public debt rose by 20% as percentage of GDP.

There are basically three ways by which a government can reduce its debt pile: 

1. The first way is through austerity, i.e. reducing government spending (and, hopefully, spending it more wisely). Austerity is not a good policy if and when the economy is in the doldrums (as is the case now) as it would further depress much needed consumption and investment. Furthermore, politically austerity measures are hard to sell to the voter base and might give rise to protests. Likewise, raising taxes to increase government revenues has similar drawbacks, whereas in many EM countries collecting tax effectively remains a challenge. 
2. The second way is for the government to increase economic growth by lifting productivity. Higher growth can translate in higher government revenues, thereby reducing fiscal deficits and, eventually, public debt. Increasing growth often involves investing in education and infrastructure, so will take time to bear fruit but required structural reforms may be hard to push through parliament as they may upset vested interest groups. However, this approach (“growing its way out of debt”) is viable if nominal growth (real growth and inflation) exceeds the interest rate and this is quite feasible, especially for countries that require only a modest debt adjustment (e.g. <10%).
3. A politically less painful third way is to boost inflation. This is equal to approach 2 but without the growth factor. Inflation eats into the real value of debt and, therefore, it becomes easier paying back debt because in nominal terms GDP is higher. Obviously, this is an effective approach if debt is denominated in the country’s own currency and if debt obligations have fixed coupons (and the central bank has not QE-ed too much bonds as this effectively transforms the coupon to floating rate) and long maturities.

We believe there is a high likelihood that inflation will eventually (in 1-2 years) rise to address the debt pile, both in the U.S. and in EM economies (directly and indirectly, being imported from the U.S.). Many economists believe low inflation is here to stay but the current coordinated monetary and fiscal stimulus coincides with credit growth and some fiscal measures put money directly in consumers’ purses. A good part of this money is or will be used to buy goods, both in the U.S. and elsewhere (Brazil’s corona vouchers, for example). Furthermore, secular trends that kept inflation at bay are probably becoming less dominant, like the increase in global trade and productivity, both very much related to China having become an important player in the global economy over the last 3 decades.

In this environment, we believe that investing in inflation-linked bonds (often referred to as “linkers”) could be a smart thing to do. Linkers earn the real rate plus realized inflation. Note that both nominal bonds and linkers are claims on the sovereign and rank pari passu. So investors demand to earn the same expected returns on these bonds and the difference between yields will reflect expected inflation (often referred to as breakeven inflation). Linkers outperform nominal bonds when realized inflation is higher than expected inflation. In the graph below one can see the potential value of this inflation protection (in this case: Turkey).

Not all EM countries offer linkers investment opportunities. The more liquid markets are in South America (Brazil, Chile and Mexico), which developed during the hyperinflationary 80s, but it is also possible to invest in Israel, South Africa and Turkey. The size of the market for EM linkers is estimated at about USD 570 billion (of which Brazil makes up about 36.5%, Mexico 19% and Israel 13%), about similar size as European corporate high yield bonds. Not big, not liquid, but sizeable enough to make a modest allocation of, say, 10% in a local currency sovereign bond mandate.

It is by no means certain that inflation will return, but even if inflation doesn’t take off, investing in linkers doesn’t hurt as (also empirically) its long-term returns are equal to those of nominal sovereign bonds. Linkers can dampen performance volatility in stress scenarios, which for most investors is a good thing to have. As the Dutch say: linkers make your portfolio less “link”…