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A debt worth more than a quarter of a trillion dollars could trigger an unprecedented cascade of defaults in the developing world, according to a Bloomberg report.
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Sri Lanka became the first country to stop paying its foreign bondholders this year. It is plagued by prohibitive food and fuel costs, which have fueled protests and political chaos as a result. Sri Lanka was followed by Russia, which went into insolvency in June under the pressure of sanctions.
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Now attention turns to El Salvador, Ghana, Egypt, Tunisia and Pakistan. These countries are now identified by Bloomberg Economics as the next most at risk of insolvency. With the rising costs of insuring developing countries against default, which are currently the highest since the beginning of the Russian invasion, even the world’s leading economists are expressing their concerns.
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A textbook example becomes a reality
“For low-income countries, debt risks and debt crises are nothing hypothetical,” World Bank Chief Economist Carmen Reinhart said on Bloomberg Television. “They’re basically there already.”
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The number of emerging market sovereign debt trading at crisis levels has more than doubled in the past six months, according to data compiled by Bloomberg.
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A period of acute problems is coming for many developing countries
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Crisis, risky or problem assets can be, for example, bonds whose returns indicate that investors believe in the real possibility of default. Together, these 19 sovereign debt countries are home to more than 900 million people, and some of them – such as Sri Lanka and Lebanon – are already insolvent.
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At stake are 237 billion dollars (5.8 trillion crowns), which belong to foreign bondholders. According to data from the Bloomberg agency, this amount represents almost a fifth of the 1.4 trillion dollars (34.1 trillion crowns) that the states of developing countries have outstanding in foreign debt in dollars, euros or yen.
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Domino effect
But it does not end with the declaration of insolvency by one of the developing countries. As has been shown repeatedly in recent decades, the financial collapse of one government can trigger a domino effect in neighboring states. Because cautious traders are withdrawing money from countries with similar economic problems and thereby hastening their collapse.
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The worst of these crises was the Latin American debt crisis of the 1980s – and according to emerging market experts, the current situation bears some similarities. As in the 1980s, the US central bank (Fed) suddenly started raising interest rates in an attempt to curb inflation, leading to a sharp increase in the value of the dollar. However, this makes it difficult for developing countries to manage their foreign bonds.
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Smaller countries with a shorter history on international capital markets tend to be under the most pressure. Larger developing countries such as China, India, Mexico or Brazil can get by with relatively solid balance sheets and foreign currency reserves.
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It doesn’t end with money
More vulnerable countries do not have such assurances, so they wait anxiously to see what will come. Political unrest linked to rising food and energy prices is rampant around the world. And according to some local politicians, spending in countries such as Ghana and Egypt should therefore be focused on helping their citizens, and not on repaying foreign bonds.
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With the Russia-Ukraine war continuing to push commodity prices, rising global interest rates and a strengthening US dollar, the burden is likely to be unbearable for some countries.
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Anupam Damani, Head of International and Emerging Markets Bonds at Nuveen, expresses deep concern about the availability of food and energy in the most vulnerable countries.
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“When it comes to social instability, there is a lot of academic literature and historical precedent that shows that higher food prices can cause that instability and that it will lead to political change as a result.”
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On the edge
A quarter of the sovereigns tracked in the Bloomberg EM USD Aggregate Sovereign Index are trading in distress, which is generally defined as a yield more than 10 percentage points higher than the yields on government bonds of similar maturities. The benchmark has fallen nearly 20 percent this year, surpassing the full-year loss it recorded during the 2008 global financial crisis.
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A population suffering from high food prices and lack of supplies can be a hotbed of political instability.
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Samy Muaddi, a portfolio manager at T. Rowe Price who helps oversee about $6.2 billion in assets, calls it one of the worst emerging market debt selloffs “probably in history.”
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He points out that many developing countries rushed to sell foreign bonds during the Covid pandemic, when spending needs were high and borrowing costs were low. Now that the world’s central banks in developed markets are tightening financial conditions and draining money from emerging markets, some of them will be at risk.
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Dark prospects
“This is a period of acute problems for many developing countries,” Muaddi said. Risk aversion has also spread to active traders seeking insurance against failure in developing markets. The price is holding just below the peak seen when Russian troops invaded Ukraine earlier this year.
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“Things could get worse before they get better,” said Caesar Maasry, head of emerging markets strategy at investment bank Goldman Sachs Group Inc. on a Bloomberg Intelligence webinar. “It’s late in the cycle. There is not a strong recovery to buy into.”
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And so, simply put, the foreign investors packed their bags and left. According to data from the Institute of International Finance, they withdrew $4 billion (97.5 billion crowns) from bonds and shares of developing markets in June, the fourth consecutive month of outflows. The initial change in investor sentiment is mainly due to the Russian invasion of Ukraine and the impact of the war on commodity prices and inflation.
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“It could have really long-term effects that will change the way we think about emerging markets, especially in a strategic context,” said Gene Podkaminer, head of research at Franklin Templeton Investment Solutions. “First of all, it confirms the reputation of developing markets – they are volatile. Investors may have seemed to have forgotten this, but now it’s hard to ignore.”
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The scenario of Sri Lanka and elsewhere
Institutions such as the International Monetary Fund have already warned of further unrest in places with dramatically rising costs of living. Prudence is needed especially where governments will not be able to provide households with sufficient support.
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Sri Lanka’s political unrest has been fueled by widespread electricity cuts and soaring inflation, which has deepened social inequality. Barclays analysts led by Christian Keller warned that a similar scenario could be repeated elsewhere in the second half of this year.
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“A population suffering from high food prices and shortages of supplies can be a hotbed of political instability,” his team wrote in a mid-year report.
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Take a look at what’s happening now in some of the world’s struggling emerging markets:
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The adoption of the cryptocurrency Bitcoin as legal tender and moves by President Nayib Bukele and his government to consolidate power have fueled concerns about El Salvador’s ability and willingness to maintain its foreign obligations – especially given its high budget deficit and $800 million in bonds due in January .
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These countries are among the more uncommon and lower-rated borrowers with low reserves that Moody’s Investors Service warns will be vulnerable to rising borrowing costs in the future.
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Both Ghana, Tunisia and Egypt have relatively low foreign exchange reserves to cover bond repayments due in 2026. This could become a problem if they are unable to convert their maturing bonds due to the increased cost of using foreign debt markets. Ghana is seeking up to $1.5 billion from the International Monetary Fund (IMF).
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Pakistan has just resumed talks with the IMF because it lacks the dollars to make at least $41 billion in debt repayments over the next 12 months. Following the example of events in Sri Lanka, protesters took to the streets against up to 14-hour power outages imposed by the authorities due to fuel shortages. While the finance minister said the country has averted insolvency, its debt is trading at problematic levels.
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The South American country is struggling after the latest of nine defaults in 2020 during a pandemic recession. Inflation is expected to exceed 70 percent by the end of the year. This increases pressure on authorities to limit the outflow of dollars from the economy and control the exchange rate. At the same time, the election of a new finance minister and the political battles between President Alberto Fernández and his Vice President Cristina Fernández de Kirchner ahead of the 2023 elections clouded the outlook for the economy.
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The invasion by Russian troops has prompted Ukrainian officials to explore debt restructuring as the war-torn country’s financing options threaten to run out, according to people familiar with the discussions. The country also said it needs $60 billion to $65 billion this year to meet funding requirements, billions more than its allies have been able to pledge so far. Politicians in Kiev are struggling to keep the budget afloat while the military fights back against a Russian invasion that has destroyed cities, halted key grain exports and driven more than 10 million people from their homes. The state also unveiled a long-term recovery plan that could exceed $750 billion.
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