Emerging markets’ debt dilemma clouds economic recovery

EMERGING market countries around the world are confronting a challenging debt dilemma, exacerbated by the confluence of rising US dollar interest rates and economic challenges resulting from the Covid pandemic and Russia’s invasion of Ukraine.

According to Fitch Ratings, a concerning trend has emerged, with a record five Fitch-rated sovereigns being in default. Notably, the period from 2020 to 2022 has witnessed sovereign defaults on average taking longer to resolve.

Since 2019, a significant number of sovereigns have experienced defaults, including Argentina, Belize, Ecuador, Russia, Suriname, Belarus, Lebanon, Ghana, Sri Lanka and Zambia. This surge in defaults reflects the economic strain on countries facing multiple crises, including the pandemic and geopolitical tensions.

Countries are grappling with elevated public debt-to-gross domestic product ratios and widening sovereign spreads. These indicators point to the financial challenges and highlight the strain on government finances. Widening sovereign spreads reflect an increased perception of risk. This translates into higher borrowing costs for these nations, making it more expensive for them to service existing debt and obtain new financing. The cycle feeds on itself, further hindering their ability to stimulate economic growth and meet essential public expenditures.

As a result of these intertwined challenges, many nations are caught in a cycle where economic recovery is impeded by high levels of debt and increased borrowing costs. The ongoing economic uncertainties and the geopolitical landscape contribute to the complexity of these issues, making it crucial for policymakers and international institutions to devise effective strategies to support the fiscal health and stability of these emerging market countries.

Over the years, most countries’ total debt-to-GDP ratios have grown. There are very few exceptions to this trend. Here are some highlights in the years from 2013 to 2023:

• Brazil’s debt-to-GDP ratio grew from 34 per cent to 60 per cent
• Mexico, from 35 per cent to 52 per cent
• South Africa, from 38 per cent to 73 per cent
• India, from 68 per cent to 77 per cent
• Thailand, from 41 per cent to 54 per cent
• Indonesia, from 23 per cent to 40 per cent
• South Korea, from 34 per cent to 54 per cent
• The Philippines, from 39 per cent to 58 per cent

For the many countries with foreign debt, the rising rates of those debts versus US interest rates were a cause for alarm. That spread (US interest rates versus emerging market dollar-debt interest rates) has widened. In 2013, the average US dollar bond yield in emerging markets was 498 basis points (bps) higher than the US rate. By 2018, the average spread increased to 543 bps.

Although the spread average does not appear significant, the individual country spread changes were often quite significant. For example, in the years 2013 to 2018, the spread for Mexico’s US dollar debt increased from 3.4 per cent to 6.3 per cent; Turkey’s from 6.4 per cent to 13.1 per cent; Egypt from 12.4 per cent to 14.8 per cent; and the Philippines from 0.9 per cent to 4 per cent.

Between 2018 and 2023, the average spread increased from 5.4 per cent to 5.8 per cent. But some countries’ spreads decreased by small amounts. For example, the spread for Brazil fell from 6.9 per cent to 6.7 per cent, and Mexico’s fell from 6.2 per cent to 4.9 per cent. But Egypt’s spread increased from 14.8 per cent to 21.2 per cent, while Turkey’s increased from 13.2 per cent to 22.1 per cent.

Of course, the most important factor is the actual interest rates that the emerging countries are now paying. For the main emerging market countries, the average interest rates on their US dollar debt from 2018 to 2023 rose from 8.4 per cent to 10.2 per cent. Interest rates of Brazil’s 10-year bonds increased from 9.9 per cent to 11.2 per cent. Mexico’s rose from 9.3 per cent to 9.4 per cent and South Africa, from 8.9 per cent to 10 per cent.

In assessing the debt scenario, the absence of data regarding China’s lending activities in emerging market countries is a problem for the World Bank and other multilateral institutions. China’s financial engagement in these regions has undergone a remarkable expansion, primarily propelled by the Belt and Road Initiative (BRI). This ambitious infrastructure and economic development effort has resulted in a significant rise in the volume of loans extended by China, and has also put many countries, such as Sri Lanka, into default and in a debt crisis.

In consequence, the large loans have compelled China to step in with emergency financing when economic challenges arise. The amounts extended by China have been enormous. Since 2008, China has committed US$240 billion to provide bailout funds to 22 countries. This financial lifeboat has been particularly crucial for nations such as Argentina, Pakistan and Sri Lanka, which are struggling with economic uncertainties and debt-related challenges caused by China’s aggressive lending for the BRI.

Most significant is the level of interest that the Chinese are charging for their loans. The Chinese interest rate for rescue loans is estimated at 5 per cent, compared with 2 per cent charged by the multilateral institutions such as the International Monetary Fund (IMF). Of course, this gap in interest rates means the borrowing countries taking the Chinese loans face increased debt challenges. Higher interest rates hamper economic recovery and reduce the ability to meet payment obligations.

One result of the high loan rates charged by China and the subsequent inability of countries to pay is that, according to the loan provisions, China is able to take control of the facilities built with the loans. For example, China was able to take control of Sri Lanka’s second biggest port, Hambantota International Port, for 99 years.

Probably the largest long-term challenge is the need for economic reforms in highly indebted countries. Organisations such as the World Bank and the IMF attempt to encourage economic reforms in the troubled countries, and raise the issue of “conditionality” where loans are conditional on reforms being adopted.

But conditionality has become a dirty word in the lexicon of countries asking for multilateral institutions’ assistance, since the reforms often require some politically painful changes, such as reducing government expenditures; privatisation of state-owned enterprises; reducing regulation of financial markets; and eliminating barriers to entry for foreign investment. Such changes can have a profound impact on real GDP growth, with an effect on debt-to-GDP ratios.

However, if a country can avoid taking the bitter medicine by accepting a Chinese loan without those conditionalities, they will often take that opportunity – to the detriment of the country’s long-term economic health.

The writer is an investment professional with more than 30 years of experience, and is co-founder of Mobius Capital Partners