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Sovereign Risk in Emerging Europe

Jamus Lim's picture

With the attention of bond market vigilantes focused on the developed economies for a change, it is nonetheless valuable to take a step back and consider sovereign risk in the post-crisis developing world. Indeed, the most recent issue of the Economist fingered Eastern European economies as having narrowly escaped the fate of the Mediterranean Europe. But is the lack of market strutiny of developing economies' debt justified? After all, the continuing problems in Dubai remind us that emerging markets are, well, emerging for a reason, and that the close-to-wholesale transfer of risk from private sector balance sheets to sovereign ones may simply be a matter of accounting that doesn't really change the underlying debt profile of a given developing economy.

A more careful look at the current sovereign debt status of emerging markets, especially with regard to the size of their debt holdings, may be in order. Of course, one can easily complain about the crudeness of standard debt-to-GDP ratios. Mea culpa. Nonetheless, placing regional debt ratios in the context of several key thresholds that have been identified in the literature on sovereign debt may be a worthwhile exercise at this point, before markets shift their attention to the next stress area, now that the Greek debt crisis has pretty much been definitively addressed (for more analysis on the issue, see the Daily post here).

Overall, the deterioration of the ECA economies' fiscal positions has led to increased concerns about their sovereign credit quality, a fact reflected in higher risk spreads for the region in general compared to the pre-crisis period (see figure). While these have compressed in recent times, the spreads for some countries, such as Hungary and Poland, remain somewhat elevated relative to their pre-crisis lows in early 2008. However, other countries---most notably Turkey---have actually seen a decline in average spreads relative to that period, which highlights the heterogeneity of the regional experience.

Source: J.P. Morgan EMBI Global.

Still, as a group, the performance of ECA sovereigns, going forward, are likely to express greater risk than other emerging and developing markets. Estimated and projected deficits for the region are all fairly large in both 2009 (the GDP-weighted average for the region is -5.7 percent) and 2010 (-3.7 percent). The regional external debt/GDP ratio is higher than the 50 percent level often regarded as sustainable for emerging markets (PDF), although lower than the Maastricht convergence ceiling of 60 percent (see figure). That said, even the 50 percent rule-of-thumb can be tenuous: In times where markets exhibit debt intolerance---where even a 20 percent debt/GDP ratio may be regarded as excessive---it may well be the case that only the Asian and Latin American economies (as a group) will manage to avoid the most punishing treatment by bond market vigilantes.

Source: IMF WEO database.

Are we being nitpicky here? Perhaps. The region, after all, has suffered through a financial crisis, and fiscal positions (along with implied debt levels) do typically spike as governments step in to backstop shaky banks and assume some share of private sector liabilities. So increased government debt is not entirely surprising, given the circumstances. Nonetheless, the sustainability of such high debt levels may mean that several of the more indebted governments may be face an elevated risk of a sovereign default (the fact that these typically follow has been extensively documented in Carmen Reinhart and Ken Rogoff's majesterial empirical study. Furthermore, the Fund's John Lipsky pretty much made the same point in a recent speech in China, where he suggested that the government debt ratio in some emerging economies had "reached a worrisome level."

The bottom line appears to be that emerging market policymakers should not be complacent and should remain vigilant for potential shifts in sovereign investor sentiment, along with the possibility of increased market scrutiny, once the problems currently faced by the developed economies of Europe begin to blow over. Announcing a clear post-crisis fiscal strategy, which outlines their sovereign debt management approaches, may well be a prudent maneuver at this time.

Update: A recent Deutsche Bank Research note (PDF) elaborates on some of the issues discussed here, and delves more deeply into the sustainability of EM public debt.