Guojin Macro: When the US and Europe Become Sources of Financial Risk

Title context: Guojin Macro: When the US and Europe Become Sources of Financial Risk Text: In past discussions of Fed rate hikes and tightening dollar liquidity, the starting point was often capital flowing back to the United States, looking for emerging market countries with high external debt and insufficient reserves. The biggest difference in this round is that emerging markets' traditional external financing buffers against a strong dollar shock have strengthened somewhat, while developed economies face greater pressure. Looking back at the policy cycle since 2022, from the UK pension crisis to the US regional bank problems and then to France's fiscal austerity predicament, developed economies' own interest rate and balance sheet risks have been repeatedly exposed. Now, the more notable marginal change lies in the fiscal burden. The fiscal expansion that could not be undone after the pandemic left higher stock debt, while primary deficits have yet to converge, and high rates continue to consume overall fiscal space through interest payment pressure. As US and European government bond yields remain high, and with concerns about the Fed's tightening cycle, financing constraints on core developed economies are increasingly strengthening, and the tightening effect will be transmitted outward along the financing cost and collateral chains. In addition, the real price-level pressure brought by high inflation is still driving the global populist cycle that has continued since 2008. Opposition parties, riding public opinion, promote welfare plans whose harms outweigh the benefits, making it harder for ruling parties to substantively advance deficit reduction. Monetary authorities, as bureaucratic institutions, are extremely small in the face of the refinancing pressure of stock debt in the rolling low-rate era, the unstoppable trend of technological development, and intensifying populism. Overall, there is a need to reassess the stability of US and European markets as the global interest rate benchmark, and this is precisely the core meaning of "the US and Europe are replacing emerging markets as the source of financial risk." I. Fiscal pressure is common, but it is more obvious in developed economies due to worsening primary deficits Fiscal pressure in both developed and emerging economies is already higher than pre-pandemic levels. Based on 2026 forecasts, the G7's three fiscal indices (total debt, interest burden, and primary deficit) are about 0.67 points higher than in 2019, slightly above EME13's 0.59 points. More noteworthy is the source of the deterioration: primary deficits contributed about half of the G7's increase, while EME13's pressure mainly comes from debt and interest payment burdens. Although the G7's fiscal pressure has not exceeded the highs of 2010 and the pre-pandemic range, it has long remained above the average level, and the problem of slow exit from fiscal expansion has become very prominent. To some extent, the market has become accustomed to occasional fiscal risks and interest rate pressure in India, Brazil, Turkey and other countries, but it treats 10-year US Treasuries above 5% and 30-year US Treasuries at 5.5% as a major threatthe core reason is that high rates in developed economies can transmit downward, while high rates in emerging economies can hardly flow upward. Rising US Treasury yields directly raise the financing benchmark for bonds and amplify selling pressure through margin calls and leverage contraction; high credit quality does not prevent developed-country government bonds from becoming the starting point of a liquidity shock. On the other hand, the resilience of developed markets also determines that no substantive sovereign risk is needed for pure market risk to constrain other assets; the decline in the stability of core developed-economy government bond yields, as well as changes in stock-bond correlation, are themselves very much worth re-examining. Therefore, it should be emphasized that emerging markets remain the pressured side, and the new shock still comes from the global financing benchmark rate itselfincluding both the higher bond yields traded out by the market and the higher policy rates set by central banks. Easing inflation can lower short-end policy rate expectations, but fiscal financing and gradually depleted duration absorption capacity still require higher long-term compensation. A very important part of this comes from the excessive indulgence of "primary deficits": if interest payment pressure still has some degree of passive attribute, namely linkage with the global rate and monetary policy cycle, then "primary deficits" are almost the result of governments' active actionsrate cuts can ease interest payment pressure, but cannot replace adjustment of fiscal revenue and expenditure itself. More critically, the side effects of debt rollover are gradually emerging. As long as maturing debt from the low-rate era carries coupons below the current level, average interest cost will continue to rise even if market rates no longer increase; if primary deficits do not converge, new financing and maturing refinancing will continue to stack up. The sensitivity of high debt to the difference between financing costs and nominal growth will also amplify accordingly. US Treasuries best illustrate this chronic pressure: from 2019 to now (2026 is an estimate), its debt ratio rose from 108.8% to 125.8%, an increase of about 17 percentage points; net interest expense as a share of fiscal revenue rose from 7.6% to 12.6%, an increase of about 5 percentage points, but the primary deficit is still standing still, remaining at about 3.5% of GDPthe stock interest burden that the economy and tax revenue still need to digest coexists with the fiscal flow that still needs financing in the future. Major European economies show clear differences, and these differences precisely show that, beyond stock debt pressure, revenue and expenditure adjustment capacity also determines the direction of pressure. France faces simultaneous increases in primary deficit, debt, and interest payment burden; Italy still has a primary surplus, but its high stock of debt makes it more sensitive to the combination of financing costs and nominal growth. Spain's primary balance has improved and its debt ratio has changed little from 2019, so it has performed better. For high-debt countries, whether a sustained primary surplus can be formed directly affects fiscal room for maneuver after financing costs risebut to achieve a primary surplus, some degree of fiscal austerity must be realized, which seems to trap developed economies in an unsolvable loop. It is worth mentioning that the above indices measure each country's pressure level relative to its own history. Scores flattening does not mean the actual situation has stopped deteriorating. The US fiscal index is only 0.07 points higher than in 2019, but the actual situation is that the US debt component has long hit the scoring ceiling, and the interest payment component is also near the ceiling, making it difficult for new burdens to continue pushing the score higher. At this point, one should return to absolute levels, namely the $40 trillion federal total debt level and the annual $1 trillion net interest expense burden. Today, the fiscal problem of developed economies lies not only in the large scale of debt, but also in the increasing difficulty of reducing deficits. However, whether raising revenue or cutting expenditure, both affect household income and are prone to voter opposition. Moreover, as populism strengthened again after the public health event, political resistance to fiscal austerity has also increased. The reason is that populism is mainly related to income distribution. As income and wealth gaps widen, voters begin to demand more protection from the government, forming different populist agendas: the left expands welfare, while the right protects domestic industry. Since then, populism has gradually become a factor affecting economic activity. Although the policies proposed by the left and right differ, both increase the difficulty of fiscal adjustment, which is mainly reflected in the intertwining of left-wing and right-wing populism from the 21st century to now. The left is more concerned with income gaps, so it advocates raising minimum wages and expanding social welfare. But to cover related spending, the left usually supports raising taxes on high-income groups and corporations. In contrast, the right is more concerned with immigration and industrial relocation, so it often advocates restricting immigration and protecting domestic firms through tariffs; at the same time, the right usually also supports tax and fee cuts. The two types of policies seem opposite, yet share one thing in common. Whether expanding welfare or reducing the tax burden, both easily win support from specific voters. Populism makes it harder for governments to solve debt problems. Because spending cuts face electoral pressure, short-term fiscal support is more easily converted into long-term burden. II. Emerging markets' buffers have clearly increased, and broad vulnerability remains stable A strong dollar easily triggers external financing crises because it simultaneously tightens financing conditions and, when there is foreign-currency liability mismatch, raises overseas entities' debt repayment pressure. If domestic credit is still expanding and the current account relies on sustained capital inflows, currency depreciation will intensify refinancing constraints. The most dangerous combination in past crises was the simultaneous imbalance of external debt, credit expansion, and external financing gaps, but that is not happening now. The fiscal deterioration of emerging economies in recent years has not significantly raised their broad vulnerability. The core reason is that fiscal conditions are only one component of risk. Using the 13-country measure with complete data on six indicators, its index is about 2.61, slightly below the 20152019 average of 2.66at that time, the Fed rate was at most only 2.5%, and 10-year US Treasuries were just above 3%. It can be said that the harsher financial environment of the past few years has actually forged stronger risk resistance in emerging market countries. For fiscal weakening to evolve into an external financing crisis, balance sheet amplification mechanisms are still needed. At present, financing gaps are smaller, credit expansion is slower, and reserves are thicker, so the same strong dollar shock is less likely to evolve into comprehensive debt pressure and a refinancing crisis. These buffers are the key to understanding the resilience of emerging markets in this round. Compared with 1997, the change in buffers is especially striking. For EME13, the average external debt/exports ratio fell from 170.4% to 127.6%, foreign reserves/GDP rose from 8.9% to 18.5%, and the current account deficit/GDP narrowed from 1.8% to 0.8%. On the one hand, the gap that needs to be filled by external funds has shrunk; on the other hand, resources for coping with capital outflows and external debt repayment have increaseda strong dollar is no longer simply "an emerging market problem," but more "a US-Europe-Japan problem." But this does not mean emerging market countries are without risk. A decomposition of EME broad vulnerability further shows that pressure is not consistent across economic factors. From 2017 to 2024, total government debt, average inflation, and foreign exchange reserves still point to greater vulnerability, but bank credit levels, current account balances, and external debt scale have formed buffers. Directly extrapolating the current Fed rate hike into a precursor to some kind of emerging market crisis ignores these real buffers and improvements in financial risk resistance. Global fiscal deterioration is common, but the strengthening of financing constraints in core developed economies is the marginal change more worthy of attention. Overall, the US and Europe need to reassess their stability as the global interest rate benchmark, and this is precisely the core meaning of "the US and Europe are replacing emerging markets as the source of financial risk." This article comes from the WeChat public account "Xuetao Macro Notes," and the author is Sinolink macro analyst Zhong Tian. GMTEight editor: Wenwen.