International | Sep 08 2022
A debt crisis wave is building for emerging markets and is likely to crash upon frontier markets and small developing economies.
-Easy finance leads to an emerging markets debt crisis
-Higher levels of local currency debt reduces odds of default
-However, most frontier market debt is US dollar-denominated
-Creditor composition of public debt is crucial
-Level of Chinese lending makes this crisis unique
By Mark Woodruff
A debt crisis wave is building for emerging markets (EMs) and is likely to crash upon frontier markets and small developing economies.
The crisis has sprung from a lack of fiscal policy constraint in the post-GFC period of easy finance, according to Oxford Economics, along with some bad luck.
While commodity importers have suffered the biggest negative terms-of trade-shock, all EMs have suffered via covid and general struggles in the global economy, including the side-effects from the Russia/Ukraine war.
The proportion of EM sovereigns suffering distress (as priced by markets) is in line with or higher than any of the global mega-crises seen in the past 25 years, points out Oxford Economics.
In examining countries (over 80 in number) with sovereign bonds outstanding, Oxford notes debt-to-GDP ratios have risen inexorably post-2010. However, the situation is considered even worse than data suggest, as defaults to private creditors are a lagging indicator of stress and show up after an enduring period of economic and financial pain.
Russia, Sri Lanka, Ukraine and Zambia have already defaulted in 2022. Other stricken EMs include Nigeria, Egypt and Pakistan, which have avoided default by issuing predominantly in local currency.
This method gives creditors of foreign currency-denominated debt a bit of space between them and a haircut (reduction in the value of debt).
This space arises because foreign currency depreciation, inflation, capital controls and negative real interest rates on local currency debt are the preferred way to reduce debt.
As a result of these alternatives, Oxford feels the likelihood of defaults may be lower than markets price in, when the share of local currency debt is high.
Most mature EMs have debt structures conducive to ‘defaultlessness’ by largely issuing debt in local currency, so it will likely never be worthwhile for them to default, points out Oxford.
Brazil, China, and India are examples of mature EMs, where total issues of US dollar-sovereign bonds each amount to less than 5% of GDP.
However, the debt of most frontier markets (less advanced economies in the developing world) is largely dollar-denominated, notes Oxford, and therefore prone to defaults once nasty shocks materialise.
The range of creditors affects who is impacted
During defaults, creditor composition of public debt is crucial in determining the severity of impact on both creditors and debtors, suggests Oxford.
As can be seen from the graph below, the range of potential creditors include bilateral and multilateral lenders.
Bilateral creditors are official agencies that make loans on behalf of one government to another government or to public and publicly guaranteed borrowers in another country.
Multilaterals include institutions such as the IMF and the World Bank, as well as other multilateral development banks.
Multilateral lenders generally don’t take haircuts from a default, according to Oxford, leaving junior creditors to take the hits. As a result, the size of creditor losses may ultimately be larger when multilaterals already have a large share in the stock of debt.
Source: Oxford Economics
By way of example, multilaterals hold more than 25% of the debt of such distressed sovereigns as Mozambique, Tunisia, Ecuador, Ukraine and Tajikistan. For these countries, exposed bondholders and bilaterals face relatively bigger haircuts.
The most comprehensive data on debt stocks (from 2017) show 38 EM sovereigns owed Chinese lenders more than 8% of GDP. It’s this predominance of China that makes this crisis unique, according to Oxford.
As China shows reticence to cooperate with other bilateral creditors (via the Paris Club) and is happy to provide emergency funding with limited conditions, resolution is more complex and drawn out.
In addition, Oxford Economics notes the important influence China has over debtors and the board of the International Monetary Fund.
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