Does Gross or Net Debt Matter More for Emerging Market Spreads?

• Published date: 01 September 2022
• Author: METODIJ HADZI‐VASKOV,LUCA ANTONIO RICCI
• Date: 01 September 2022
• DOI: http://doi.org/10.1111/jmcb.12878

DOI: 10.1111/jmcb.12878

METODIJ HADZI-VASKOV

LUCA ANTONIO RICCI

Does Gross or Net Debt Matter More for Emerging

Market Spreads?

Does gross or net debt matter for long-term sovereign spreads in emerging

markets? The topic is important for understanding the borrowing cost im-

plications of public asset–liability management decisions (e.g., using assets

to lower debt). We investigate this question using data on emerging market

economies (EMEs) over the period 1998–2014. Wend that both gross debt

and assets have a signicant impact on long-term sovereign bond spreads in

emerging markets, with effects roughly offsettingeach other (coefcients of

opposite sign and similar magnitude). Hence, net debt seems more appropri-

ate than gross debt when evaluating the impact of indebtedness on spreads.

The empirical results suggest that an increase in net debt by 10 percentage

points of GDP implies an increase in the spread by 100–120 basis points,

and the effect is larger during periods of domestic distress. The key results

from this empirical study are quite robust to alternative specications and

subgroups of EMEs.

JEL codes: E43, G15, H63

Keywords: emerging markets, governmentdebt, net debt, sovereign bond

spreads

W     rationale for a

positive relationship between the level of government debt and spreads (or interest

rates) on sovereign bonds, the literature is agnostic when it comes to whether gross

debt or debt net of government nancial assets is the relevant measure to consider.

While standard economic intuition would suggest that debt net of assets (at least

liquid ones) should be more important, most of the empirical literature has focused

on gross debt. Do nancial markets value nancial assets held by emerging market

governments, when assessing the impact of gross debt on the sovereign spread? This

Wewould like to thank Valerie Cerra, Alfredo Cuevas,Marcello Estevao, Camila Henao-Arbelaez, An-

dras Komaromi, Maurice Obstfeld, Robert Rennhack, Jan KeesMartijn, Nelson Sobrinho, and participants

at the WHD seminars for useful comments and suggestions.

M H-V  L A R are with the International Monetary Fund

(Email: mhadzivaskov@imf.org and lricci@imf.org).

Received June 6, 2017; and accepted in revised form January 11, 2019.

Journal of Money, Credit and Banking, Vol. 54, No. 6 (September 2022)

© 2021 The Ohio State University.

1778 :MONEY,CREDIT AND BANKING

paper aims to shed empirical evidence on this matter for emerging markets, on the

basis of data that have recently become available.

According to standard economic arguments, an increase in government debt

through issuance of new liabilities raises the sovereign default risk, which should

in turn increase the corresponding spreads in order to compensate investors for the

higher risk. Similarly, a rapid expansion of governmentdebt creates an excess supply

of such assets relative to the diversied portfolio benchmark investors aim to hold. In

turn, investors would require a higher return (and spread) for their demand to exceed

the original benchmark.1

However, the literature has generally remained silent on whether gross or net debt

matters for sovereign spreads, most likely because the limited data availability on

net debt until recently would limit the ability to test empirically which measure was

more relevant, as the lack of data may haveaffected the underlying economic relation

itself. As recent data-gathering efforts have providedthe availability of such data, it is

natural to wonder what we should expect, as theoretical arguments can go both ways.

On the one hand, if the government owns assets that are publicly known, liquid,

and not tied to specic (scal or monetary) policy objectives (such as pension obli-

gations), these assets should matter for the considerations above. In other words, to

the extent nancial markets can access information on liquid assets, they should use

such information even if ofcial data are not available,and net debt should be a more

relevant measure of indebtedness. On the other hand, the lack of a comprehensiveand

well-established data set on assets for emerging markets until recently would tilt the

argument in favor of gross debt: to the extent the lack of public data preventednan-

cial markets from adequately assessing assets when gauging sovereign risk, assets

would have been ignored and gross debt would be the relevant variable to consider.

One may think that nancial experts rely on a broader set of sources of information

than publicly available data, and that they have generally been aware of signicant

asset positions. Or they may not really use it even if they can access such informa-

tion, for example, as they doubt the quality or comparability or because gross debt is

the metric traditionally used. It is therefore an empirical matter to assess which debt

measure is more relevant in assessing spreads and whether nancial markets consider

nancial assets held by emerging market governments in undertaking this task.

As an illustration, Figure 1 depicts the relationship between gross sovereign debt

and sovereign spreads (left panel) or assets and spreads (right panel) for emerging

markets in 2014. Both relations seem to hold with the right sign (positive and negative,

respectively), which would tend to suggest that net debt matters. The paper formally

investigates this claim by testing the relative importance of gross debt and assets for

emerging market sovereign spreads.

The question is very important for all policy decisions related to public asset—

liability management decisions, especially for countries with signicant asset

1. For example, see Gruber and Kamin (2012) for some theoretical arguments about the relationship

between government debt levels and spreads/interest rates on government debt.