A colossal quarter-trillion-dollar distressed debt is about to bring about an avalanche of unprecedented defaults in developing countries.
Due to unmanageable food and fuel prices that sparked protests and political unrest, Sri Lanka was the first country to stop paying its foreign bondholders. Following its entanglement in a web of sanctions, Russia followed in June 2022.
Sri Lankan economists consider default risk in 2023 to be El Salvador, Ghana, Egypt, Tunisia, and Pakistan. The concern comes from World Bank Chief Economist Carmen Reinhart and long-term emerging market debt experts like former Elliott Management portfolio manager Jay Newman as the cost to insure emerging-market debt from non-payment surges to the highest level since Russia invaded Ukraine in 2022.
Carmen Reinhart said, “Debt dangers and debt crises are not hypothetical in low-income countries. We’re pretty much there already.”
The number of emerging nations with sovereign debt that trades at distressed levels, yields that show investors feel default is a serious possibility, has more than doubled in the previous six months. More than 900 million people live in those 19 countries, and some of them, like Sri Lanka and Lebanon, are already in default.
Therefore, $237 billion of notes currently trading distressed are at risk due to foreign bondholders. According to data, that amounts to about a fifth, or roughly 17%, of the $1.4 trillion in external debt emerging-market sovereigns have outstanding, denominated in dollars, euros, or yen.
And as crises have repeatedly demonstrated in recent years, the financial collapse of one country can have a cascading effect, or what is known as “contagion,” as nervous investors pull money out of nations that are experiencing similar economic difficulties, hastening the demise of other countries. The 1980s Latin American debt crisis was the mother of such crises.
Emerging-market observers claim that the current situation is similar to a certain extent. Similarly, the Federal Reserve is raising interest rates rapidly to stop inflation, which has caused the dollar’s value to soar and made it difficult for developing countries to service their foreign debt.
Smaller nations with a more recent history of international capital markets are frequently those that are most under pressure. Larger developing countries like China, India, Mexico, and Brazil can claim to have solid external balance sheets and foreign exchange reserve holdings.
However, there is a lot to worry about the future in nations that are more at risk. Worldwide political unrest is escalating in response to rising food and energy prices, throwing doubt on the future bond payments in heavily indebted countries like Ghana and Egypt, some argue it would be better served by utilizing the funds to aid their citizens. In addition, the cost for certain countries may be unacceptable due to the Ukraine war, rising interest rates, and the dollar’s dominance.
Reaching the limit
A quarter of the countries monitored by the Bloomberg EM USD Aggregate Sovereign Index have distressed trading, commonly characterized as yields more than ten percentage points higher than those on Treasury securities of comparable maturity.
The gauge has fallen nearly 20% in 2023, surpassing the full-year loss it recorded in 2008 during the global financial crisis. Naturally, some result from significant losses in the underlying rate markets, but credit degradation has been a critical factor for the most troubled countries.
Samy Muaddi, a portfolio manager at T. Rowe Price who assists in managing assets worth approximately $6.2 billion, says it was “probably” one of the worst sell-offs of emerging-market debt ever.
He points out that many emerging nations hurried to sell foreign bonds during the COVID period when spending requirements were high and borrowing costs were low. Some will now be at risk as central banks in developed countries tighten financial conditions, forcing money out of emerging markets and leaving them with high expenses.
This is a challenging time for many developing nations, according to Samy Muaddi.
Active traders buying insurance against default in emerging markets are victims of the spread of risk aversion. However, the price is still slightly below its peak from earlier 2022, when Russia invaded Ukraine.
During a Bloomberg Intelligence Webinar, Caesar Maasry, head of emerging-market cross-asset strategy at Goldman Sachs Group, said, “Things might get worse before they get better. The cycle is late. There isn’t a convincing recovery to believe in.”
Foreign money managers have fled developing economies as a result. According to the Institute of International Finance, investors withdrew $4 billion from emerging-market bonds and stocks in June 2022, marking a fourth consecutive month of outflows as the Russian invasion of Ukraine and the war’s effects on commodities prices and inflation weighed on investor mood.
According to Gene Podkaminer, head of research at Franklin Templeton Investment Solutions, “This might have long-term consequences that affect the way we think about emerging markets, particularly in a strategic framework.”
“The first thing it does is confirm that emerging markets are notorious for being unpredictable. There have undoubtedly been times when investors may have forgotten this, but it’s becoming increasingly difficult,” the official commented.
Increasingly sharp trade-offs between keeping interest rates accommodative to support shaky post-COVID recoveries and tightening rates to preserve currencies and suppress inflation are raising central bankers’ concerns about ballooning bond spreads. In addition, multilateral organizations like the International Monetary Fund have warned of increased conflict due to rising living costs, particularly in areas where governments are ill-equipped to protect households.
Widespread electricity outages and soaring inflation increased inequality and contributed to Sri Lanka’s political unrest. According to Christian Keller and other Barclays Plc analysts, that might happen somewhere in the second half of this year.
His team stated in a mid-year study that “populations suffering from high food costs and shortages of supply can be a tinderbox for political instability.”
What happens when a country defaults?
In theory and in a perfect world, governments would receive money through taxes and investments to cover their debts. However, governments frequently borrow money and spend beyond their means, just like people do. Governments do this by issuing bonds committed to repaying the bond’s face value plus interest at the maturity rate.
The national/sovereign debt is the sum of a country’s internal and external debts. Bonds that the government issues and sells to international investors in foreign currencies are known as external obligations. Internal debts are obligations to citizens of the same nation.
Fiscal and monetary policy can finance internal debts by increasing taxes and printing more money. Still, external debts can take money away from other sources of income because they must be repaid in currencies that the government does not control. So what follows a default by a nation?
If an individual/business files for bankruptcy, the creditors can seize the assets. However, its creditors cannot take a country’s help, and the government cannot be forced to make payments in the event of a default using funds it does not have.
This is false for the nation’s assets that are located abroad. For example, Argentina’s naval training ship in Ghana was confiscated after it fell into default in 2012.
The creditor of the defaulting nation’s only choice is to renegotiate the loan’s terms. As a result, the value of government bonds will be “haircut,” or rescheduled, for postponed payment.
Argentina committed to pay back a third of its debt to creditors after missing an $81 billion loan payment in 2011. In this sense, 93% of the debt was converted into performing securities between 2005 and 2010. However, Argentina didn’t give the vulture fund its money back for the remaining 75% of the debt until 2016.
What effects does moving into default have?
The immediate default cost is the loss of principal and capital to the creditor due to a partial debt cancellation or restructuring.
The government is more likely to forgive debts owed to foreign private creditors since reprisal is less likely.
Additionally, like in any other crisis, government defaults lead to skyrocketing inflation, unemployment, and political pressure on the defaulting government.
Instability in the financial system leads to bank runs since domestic banks carry most household debt. Bank runs happen when a sizable sum of money is removed from a bank due to public anxiety and a lack of trust. The government aims to restrict the amount of money each depositor can withdraw through capital restrictions, which are in place to prevent this.
Greek banks were forced to close for nearly 20 days in June 2015, restrict bank transfers to foreign institutions, and cap cash withdrawals at €50 per day to prevent a banking crisis. In addition, a sovereign debt crisis may result in economic and currency crises as overall demand declines and the global market loses faith in the nation’s currency.
The inability of a defaulting nation to access the credit market is another predictable effect. It will either receive a loan at a high-interest rate or none at all. As a result, the defaulting nation’s credit rating will drop, discouraging international investment.
The current situation with debt and default in the third world is a cause for concern among economists and emerging market debt experts. The risk of default is high, and several countries are already experiencing it. The increasing food and fuel prices have sparked protests and political unrest, leading to some countries stopping payments to foreign bondholders. The worry is that this will lead to a contagion effect, where nervous investors pull money out of other nations, causing them to default.
The situation is similar to the Latin American debt crisis of the 1980s, and the Federal Reserve’s rapid interest rate hikes to stop inflation are making it difficult for developing countries to service their foreign debt. The smaller nations with a more recent history of international capital markets are most under pressure, but even larger developing countries may be affected by the crisis. The consequences of a default are severe, leading to skyrocketing inflation, unemployment, and political pressure on the defaulting government.
The inability to access the credit market discourages international investment, and bank runs happen when a sizable sum of money is removed from a bank due to public anxiety and a lack of trust. The situation is challenging, and the worry is that it may get worse before it gets better.