Soaring inflation, a strong dollar and a complete overhaul of global energy markets are playing hell with Emerging Market debt. The world is now teetering on the edge of a global debt crisis, warns Oxford Economics in a research paper released on September 6.
“The latest emerging market (EM) debt crisis is upon us, with the dollar-denominated debt of 25 EM sovereigns trading at yields of more than 1,000 bps,” Gabriel Sterne, the head of global EM research at Oxford Economics, said in a note emailed to clients. “Because this wave is only just breaking and is likely to crash on frontier markets and small developing economies this time around, it hasn’t yet grabbed the same headlines as 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 time it reared its head in the 1970s led to multiple financial crises as debt loads became unmanageable. Sri Lanka’s economy has already blown up, causing a change of government, and at least four African countries, including Ghana, Egypt, Mozambique and Angola, have already been driven into the arms of the IMF after their public finances became untenable. And things are likely to only get worse.
Mature EM sovereigns usually choose default or devaluation to get out their bind. Having issued predominantly in local currency, the preferred way to reduce debt has been a deep depreciation, stoking inflation, introducing capital controls and negative real interest rates on local currency debt.
“Among stricken EMs this time, Nigeria, Egypt, Pakistan each fall into that category, giving creditors of FX-denominated debt a bit of space between them and a haircut,” says Sterne. “But the debt of most frontiers is predominantly dollar-denominated – and therefore prone to defaults once nasty shocks materialise.”
The dollar’s rise has been turning the screws intolerable tight this year, up some 20% since the start of this year. And much of this debt is owed to international financial institutions (IFIs) that usually don’t accept haircuts when doing debt restructuring deals. Of distressed sovereigns, multilaterals hold more than 25% of the debt of Mozambique, Tunisia, Ecuador, Ukraine and Tajikistan, reports Oxford Economics.
Of those in trouble, Ukraine is one of the few to have already agreed debt relief with its main sovereign creditors, who have granted Kyiv a two-year coupon and redemption holiday while it is under attack by Russia. However, even with this help, Ukraine has borrowed large amounts of money in its effort against Russia’s invasion and must pay $10.1bn in debt by the end of 2022.
On top of the pressure EM and frontier markets are feeling thanks to their IFI borrowing, many countries have also over-borrowed from China and are struggling to meet payments. In Europe tiny Montenegro has already run into trouble after its public debt reached 84.75% of GDP in 2021 and it was unable to repay Chinese loans to build the Bar-Boljare motorway.
Sovereign stress building
EMs are facing a perfect storm, as they were just emerging from two years of the coronavirus (COVID-19) pandemic that had already put most counties’ balance sheets under strain. The global inflation surge and soaring energy costs hit hard at governments already in a weakened position. Debt-to-GDP ratios have risen inexorably after 2010.
“We focus on the 80+ sovereigns with sovereign bonds outstanding. The profile of the 75th percentile of the debt-to-GDP distribution is a good place to look for risks of widening stress; it increased dramatically, from 45% in 2010 to 68% in 2019. And then it rocketed to 83% after the COVID-crisis and supply shocks,” says Sterne.
And the first defaults are already appearing, including Russia, Sri Lanka, Ukraine and Zambia, which is a 20-year high, but still below the defaults that followed the stagflation episode in the 1970s and that went on to cause financial crises in the 1980s.
The situation is even worse than this data suggests, Sterne argues, as defaults come at the end of a period of distress, but the prices on the bonds are forward looking and the price of EM debt has already jumped to 25-year highs, with the dollar-denominated debt of around 25 EM sovereigns trading at yields of more than 1,000 bps since the start of this year.
The 1980s experience reveals how defaults can come in waves triggered by a terms-of-trade shock. Most commodity producers defaulted at least once during that period, Oxford Economics reports.
“This time the impact is less focused on any particular group of economies. Commodity importers have suffered the biggest negative terms-of-trade shock, but all EMs suffered under Covid and generalised struggles in the global economy, including the fallout from Russia's war on Ukraine,” says Sterne.
No one likes to restructure their debt, but how that debt up is made affects their ability to do restructuring deals if forced to.
Holders of local currency assets are typically a soft target for debt reduction for governments. A currency depreciation immediately cuts debt but typically causes high inflation. Capital controls also allow a government to impose negative real interest rates on local currency instruments, which also reduces debt. The bigger the share of local currency debt in the total debt, the bigger the incentive to depreciate rather than default on FX debt.
The good news for holders of sovereign bonds that are denominated in foreign exchange is that most mature EMs have largely issued debt in local currency, a process facilitated by Clearstream that has been connecting local debt markets to the international system, allowing traders in London and New York to participate directly on exchanges in places like Moscow or Kyiv. The dramatic shift came between 2004 and 2012, when the average share of local currency issues in total external sovereign debt in larger EMs increased dramatically, to 60% from 15% reports Oxford Economics. For example, Brazil, China and India's total issues of dollar-sovereign bonds each amount to less than 5% of GDP, so it will likely never be worthwhile for them to default.
Smaller, less mature frontier markets have not connected their markets to the international system, making it onerous for international investors to tap their bond markets and leading those countries to have a much larger share of FX obligations. Of the 19 most distressed sovereigns, only four have domestic debt greater than 60% of the total. Sovereign spreads of these four are nevertheless temptingly high (Egypt >900bps, Nigeria >780bps, Pakistan >1200bps and Argentina >2400bps), reports Oxford Economics.
“Three of the four have demonstrated a long-standing capacity to tap local markets for funding (Argentina is a more complex story), and there may be a case to argue markets are underestimating the role of domestic funding in shielding dollar-debt from default,” says Sterne. “A big risk for all four is that domestic funding pressures result in pressures on the current account. For them, fiscal stress would most likely transmit to crisis via a pressure on currency and the resulting drain in FX reserves (though only Argentina and Nigeria currently have very low reserves).”
But most of the counties in distress have relatively low levels of domestic debt: Tunisia, Mozambique, Angola, Tajikistan, El Salvador, Ecuador and Cameroon each has domestic debt under a third of the total. “For these, when debt reduction is needed, attention will go directly to haircuts,” says Sterne.