Rampant inflation, a strong dollar and a complete overhaul of global energy markets play a hellish role with emerging market debt. The world is now on the verge of a global debt crisis, warns Oxford Economics in a research paper published on September 6.
“The latest emerging market (EM) debt crisis is upon us, with the dollar-denominated debt of 25 emerging market sovereigns trading at yields of over 1,000 basis points,” said Gabriel Sterne, head of Global Emerging Markets Research at Oxford Economics, in a statement. note emailed to customers. “Because this wave has only just broken and is likely to collapse in frontier markets and small developing economies this time around, it hasn’t hit the headlines yet than the last wave of sovereign defaults in the 1980s – when most commodity exporters defaulted at least once.”
Earlier this year, the International Monetary Fund (IMF) warned that the world was facing stagflation, which last appeared in the 1970s, leading to multiple financial crises as the debt burden was becoming unmanageable. Sri Lanka’s economy has already boomed, prompting a change of government, and at least four African countries, including Ghana, Egypt, Mozambique and Angola, have already been pushed into the arms of the IMF after their public finances have become unsustainable. And things will probably only get worse.
Mature emerging sovereigns generally choose default or devaluation to get out of their impasse. Having issued primarily in local currency, the best way to reduce the debt was a steep depreciation, stoking inflation, introducing capital controls and negative real interest rates on local currency debt.
“Of the emerging markets affected this time around, Nigeria, Egypt and Pakistan each fall into this category, giving creditors of foreign currency-denominated debt some space between them and a haircut.” , says Sterne. “But most borders’ debt is mostly denominated in dollars – and therefore prone to defaults once nasty shocks materialize.”
The rising dollar has been unbearably tight this year, up about 20% since the start of this year. And much of this debt is owed to international financial institutions (IFIs) which generally do not accept haircuts when entering into debt restructuring agreements. Among struggling sovereigns, multilaterals hold more than 25% of the debt of Mozambique, Tunisia, Ecuador, Ukraine and Tajikistan, reports Oxford Economics.
Among the troubled countries, Ukraine is one of the few to have already agreed debt relief with its major sovereign creditors, who gave Kyiv a two-year coupon and repayment holiday as it is attacked by Russia. However, even with this aid, Ukraine has borrowed large sums of money in its efforts against the Russian invasion and must pay off $10.1 billion in debt by the end of 2022.
In addition to the pressure emerging and frontier markets are feeling from borrowing from the IFIs, many countries have also overborrowed from China and are struggling to meet their payments. In Europe, tiny Montenegro has already struggled after its public debt reached 84.75% of GDP in 2021 and it was unable to repay Chinese loans for the construction of the Bar highway. -Boljara.
Sovereign Stress Construction
Emerging markets are facing a perfect storm, having just emerged from two years into the coronavirus (COVID-19) pandemic which had already strained the balance sheets of most countries. Soaring global inflation and soaring energy costs have hit already weak governments hard. Debt-to-GDP ratios rose inexorably after 2010.
“We focus on the 80+ sovereigns with outstanding sovereign bonds. The profile of the 75th percentile of the debt-to-GDP distribution is a good place to look for risks of worsening tensions; it increased dramatically, from 45% in 2010 to 68% in 2019. And then it jumped to 83% after the COVID crisis and supply shocks,” explains Sterne.
And the first defaults are already appearing, notably in Russia, Sri Lanka, Ukraine and Zambia, which is at a 20-year high, but still below the defaults that followed the stagflation episode in the 1970s. and which caused financial crises in the 1980s.
The situation is even worse than these data suggest, argues Sterne, because defaults come at the end of a period of distress, but bond prices are looking forward and the price of debt markets markets has already reached 25-year highs, with the dollar-denominated debt of around 25 emerging market sovereigns trading at yields above 1,000 basis points since the start of this year.
The experience of the 1980s reveals how defaults can occur in waves triggered by a terms-of-trade shock. Most commodity producers have defaulted at least once during this period, reports Oxford Economics.
“This time, the impact is less concentrated on a particular group of economies. Commodity importers have suffered the biggest negative terms-of-trade shock, but all emerging markets have suffered from Covid and widespread struggles in the global economy, including the fallout from Russia’s war on the coronavirus. ‘Ukraine,” says Sterne.
No one likes to restructure their debt, but the way that debt is built up affects their ability to enter into restructuring agreements if forced to.
Holders of local currency assets are generally an easy target for government debt reduction. A depreciation of the currency immediately reduces the debt, but usually causes high inflation. Capital controls also allow a government to impose negative real interest rates on local currency instruments, which also reduces debt. The larger the share of local currency debt in total debt, the greater the incentive to depreciate rather than default on foreign currency debt.
The good news for holders of sovereign bonds denominated in foreign currencies is that most mature emerging markets have largely issued local currency debt, a process facilitated by Clearstream which has connected local debt markets to the international system, allowing traders from London and New York York to participate directly in trades in places like Moscow or Kyiv. The sea change occurred between 2004 and 2012, when the average share of local currency issuance in the total external sovereign debt of major emerging markets increased dramatically, from 15% to 60% according to Oxford Economics. For example, the total dollar sovereign bond issues of Brazil, China and India are each less than 5% of GDP, so it will probably never be useful for them to default.
Smaller and less mature frontier markets have not connected their markets to the international system, making it difficult for international investors to tap into their bond markets and leading these countries to have a much larger share of foreign exchange bonds. Of the 19 most troubled sovereign states, only four have domestic debt above 60% of the total. The sovereign spreads of these four countries are nevertheless tempting (Egypt >900bps, Nigeria >780bps, Pakistan >1200bps and Argentina >2400bps), reports Oxford Economics.
“Three of the four have demonstrated a long-standing ability to tap into local markets for financing (Argentina is a more complex story), and there may be arguments that markets underestimate the role of financing national in protecting dollar debt from default,” Sterne says. “A big risk for all four is that domestic funding pressures lead to pressures on the current account. For them, the budgetary pressures would most likely be transmitted to the crisis via pressure on the currency and the resulting drain on foreign exchange reserves (although only Argentina and Nigeria currently have very low reserves).
But most of the troubled countries have relatively low levels of domestic debt: Tunisia, Mozambique, Angola, Tajikistan, El Salvador, Ecuador and Cameroon each have domestic debt below a third of the total. “For these, when debt reduction is needed, the focus will go directly to haircuts,” Sterne says.