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Fiscal dominance: Emerging markets’ upper-hand

  •   VanEck
  •   21 March 2024
  •      
  •   

Executive Summary

  • Fiscal dominance is an economic condition that arises when debts and deficits are so high that monetary policy loses traction.
  • The absence of ‘fiscal dominance’ in emerging markets (EM) helps explain why EM hard-currency bonds outperformed their developed markets (DM) counterparts for the past 20 years.
  • Emerging markets’ superior fiscal and monetary policy stance is also beginning to generate better risk/return statistics in EM local-currency bonds.
  • Low debt and deficits have allowed emerging markets monetary authorities to conduct inflation-focused monetary policy, while high debt and deficits in developed markets have diluted central bank independence and their focus on inflation.
  • The result of developed markets’ ‘fiscal dominance’ has, in recent decades, meant that all financial crises since 1998 basically involve the large developed markets.
  • The result is also declining inflation risks in emerging markets, but rising inflation risks in developed markets.
  • The deficit-producing developed markets need financing from the surplus-producing emerging markets, but the emerging markets are increasingly geopolitical rivals with developed markets, increasing risks to developed markets.
  • Within emerging markets, Asia is the first beneficiary, with the strongest policy track record and the strongest results in terms of historic bond performance and anchored inflation.
  • For investors, this means that an allocation to emerging market bonds is an important part of a global bond portfolio, and we think an unconstrained approach is the best way to take advantage of opportunities within EM bonds.

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