Over the next five years, government debt in the G4 (US, Japan, Germany and the UK), with the exception of Germany, will rise very significantly. The G4 will therefore have to undergo a multi-year fiscal adjustment in order to put debt on a sustainable path. By contrast, the BRIC governments, having weathered the global crisis fiscally unscathed, will see their debt levels largely unchanged and face a very limited or even non-existent need for a fiscal adjustment. Even if BRIC public sectors were forced to take on contingent liabilities (e.g. in case of a banking sector bail-out), they would still be in better shape, financially speaking, than the G4.
Public debt matters – economically and politically. A high and rising level of public sector debt will, sooner or later, push up domestic interest rates, crowd out private-sector investment and eventually threaten government solvency. Rising debt levels also limit fiscal flexibility, ultimately forcing governments into an extended fiscal retrenchment. This can have consequences reaching far beyond the economic realm. A very large debt burden, for instance, forced Great Britain to liquidate its empire following WWII. Similar concerns have informed recent analyses by US foreign policy in the context of an unsustainable US fiscal policy (Bacevich, Johnson, Mandelbaum).
Over the next five years, government debt is set to decline moderately in the BRICs, while it will rise dramatically in the G4 (US, Japan, Germany and the UK), with the exception of Germany. The G4 will therefore have to undergo a multi-year fiscal adjustment in order to put debt on a sustainable path. By contrast, the BRIC governments, having weathered the global crisis fiscally unscathed, will see their debt levels largely unchanged and face a very limited or even non-existent need for a fiscal adjustment. A combination of significantly lower fiscal deficits, faster economic growth and higher inflation will ensure debt sustainability. According to IMF estimates, the fiscal deficit in the BRIC will average 3.1% of GDP versus 5.6% of GDP in the G4. The real (inflation-adjusted) deficits in the BRIC will be even smaller, of course.
That said, the level of government debt in the BRIC countries varies substantially. Gross general government debt in Brazil and India amounts to a sizeable 67% and 75% of GDP, respectively, while in China and Russia it stands at a very low 20% and 10% of GDP, respectively. It is also noteworthy that BRIC government debt is almost exclusively held by residents. Only in Brazil do foreigners own a little more than 10% of total government debt. This contrasts sharply with Germany (50%), the UK (30%) and the US (50%), where foreigners hold much larger shares of government debt. If government and central bank balance sheets are consolidated, the public sectors in the BRICs are also all net foreign (currency) creditors. China’s public sector owns net foreign assets worth a stunning – for a country the size of China – 50% of GDP. A very low dependence on foreign financing sharply limits BRIC governments’ financial vulnerability.
Recently, many analysts have expressed concern about the size of (more broadly defined) public sector debt and contingent liabilities in the BRICs (and especially in Brazil and China). Non-financial public sector (NFPS) debt comprises, in addition to the debt of the general government sector, the liabilities of the central bank and nonfinancial public-sector-owned companies. Net NFPS debt, the more relevant indicator from a debt sustainability perspective, amounts to a very manageable 40% of GDP in Brazil, the only BRIC country providing consolidated PS figures. Russia has no doubt the lowest net NFPS debt – the general government is net creditor, after all! For both India and, even more so, China, wide-spread government ownership of non-financial (let alone, financial) companies at both the central and local government levels make it virtually impossible to estimate net public debt with any degree of accuracy.
The Chinese authorities have just released estimates of direct and explicitly-guaranteed local-government debt, a source of concern to analysts following the massive surge in bank lending to local governments in 2008-09, putting it at a manageable 27% of GDP. India has been providing more comprehensive state government debt statistics all along. Neither country provides NFPS estimates. However, unless one assumes that the liabilities owed by public sector companies vastly exceed their assets, net NFPS is bound to be sustainable in all BRICs given the combination of (strong) economic growth, (generally small) government deficits and (low) real interest rates.
What about contingent liabilities? Past experience suggests that banking sector crises are the single most important source of contingent liabilities. All BRIC economies have been experiencing strong real credit growth over the past two years, raising concerns about a future rise in non-performing loans and the potential need for the government to extend financial support to the banking sector. All other things equal: the larger the size of the banking sector and the larger the share of lending by government-owned banks, the greater the potential liabilities. Bank lending to the private sector amounts to 50% of GDP in Brazil, India and Russia and a very considerable 135% of GDP in China. Government-owned banks account for 50% of total banking sector assets in China, 40% in both Brazil and Russia and 70% in India. Ceteris paribus this suggests that China faces the potentially largest contingent liabilities as a share of GDP. Admittedly, in the event of a systemic banking crisis, governments often have little choice but to bail out banks regardless of ownership.
Naturally, credit quality, capital buffers and profitability also affect the level of contingent liabilities. Fitch estimates that the Chinese banking system might require financial support in the order of 10-30% of GDP in a moderate and severe stress scenario, respectively. Bail-out costs in the other BRIC countries would be significantly smaller given the much smaller size of their banking sectors. In short, the contingent liabilities associated with even a severe banking sector crisis would not undermine debt sustainability in any of the BRICs. China, facing potentially the largest contingent liabilities, is best placed to sustain an increase in liabilities given that it enjoys the strongest economic growth outlook, has comparatively little debt and a captive domestic investor (depositor) base. If, unrealistically, all the debt of all non-financial public-sector entities, including central and local governments, were added up and assumed by the central government, Chinese gross public debt may add up to 150% of GDP or so (before intra-public sector netting!). Even in this scenario, this would not break the “sovereign” bank – even if real GDP growth declined substantially (from 10% to 6%), real interest rates rose (by 200bp) and the primary fiscal balance worsened (by 1% of GDP).
In sum, even if BRIC public sectors were forced to take on contingent liabilities, they would still be in better shape, fiscally speaking, than the G4. This does not, however, necessarily translate into higher sovereign risk in the G4, for the latter have a number of things going for them (e.g. large, diverse and “deep” investor base, solid political and economic institutions, a strong debt service track record). Nonetheless, financially and politically, the BRICs will benefit from far greater fiscal flexibility than the advanced economies over the next decade and beyond, off-balance sheet liabilities notwithstanding. Higher underlying growth will increase BRIC governments’ fiscal resources relative to the G4. This will have wide-ranging consequences for the economic and political position of the BRIC relative to the G4.