Historic cascade of defaults is coming for emerging markets

Many EMs are on the edge.
Street vendors at a local market in San Salvador, El Salvador. The nation has faced repeated slashing of its credit rating. Image: Armando Constanza/Getty Images

A quarter-trillion dollar pile of distressed debt is threatening to drag the developing world into a historic cascade of defaults.

Sri Lanka was the first nation to stop paying its foreign bondholders this year, burdened by unwieldy food and fuel costs that stoked protests and political chaos. Russia followed in June after getting caught in a web of sanctions.

Now, focus is turning to El Salvador, Ghana, Egypt, Tunisia and Pakistan — nations that Bloomberg Economics sees as vulnerable to default. As the cost to insure emerging-market debt from non-payment surges to the highest since Russia invaded Ukraine, concern is also coming from the likes of World Bank Chief Economist Carmen Reinhart and long-term emerging market debt specialists such as former Elliott Management portfolio manager Jay Newman.

“With the low-income countries, debt risks and debt crises are not hypothetical,” Reinhart said on Bloomberg Television. “We’re pretty much already there.”

The number of emerging markets with sovereign debt that trades at distressed levels — yields that indicate investors believe default is a real possibility — has more than doubled in the past six months, according to data compiled from a Bloomberg index. Collectively, those 19 nations are home to more than 900 million people, and some — such as Sri Lanka and Lebanon — are already in default.

At stake, then, is $237 billion due to foreign bondholders in notes that are trading in distress. That adds up to almost a fifth — or about 17% — of the $1.4 trillion emerging-market sovereigns have outstanding in external debt denominated in dollars, euros or yen, according to data compiled by Bloomberg.

And as crises have shown over and over again in recent decades, the financial collapse of one government can create a domino effect — known as contagion in market parlance — as skittish traders yank money out of countries with similar economic problems and, in so doing, accelerate their crash. The worst of those crises was the Latin American debt debacle of the 1980s. The current moment, emerging-market watchers say, bears a certain resemblance. Like then, the Federal Reserve is suddenly ratcheting up interest rates at a rapid-fire clip in a bid to curb inflation, sparking a surge in the value of the dollar that is making it difficult for developing nations to service their foreign bonds.

Those under the most stress tend to be smaller countries with a shorter track record in international capital markets. Bigger developing nations, such as China, India, Mexico and Brazil, can boast of fairly robust external balance sheets and stockpiles of foreign currency reserves.

But in more vulnerable countries, there’s widespread concern about what’s to come. Bouts of political turmoil are arising around the globe tied to soaring food and energy costs, casting a shadow over upcoming bond payments in highly-indebted nations such as Ghana and Egypt, which some say would be better off using the money to help their citizens. With the Russia-Ukraine war keeping pressure on commodity prices, global interest rates rising and the US dollar asserting its strength, the burden for some nations is likely to be intolerable.

For Anupam Damani, head of international and emerging-market debt at Nuveen, there’s deep concern about maintaining access to energy and food in developing economies.

“Those are things that are going to continue to resonate in the second half of the year,” she said. “There’s a lot of academic literature and historical precedence in terms of social instability that higher food prices can cause, and then that can lead to political change.”

At the edge

A quarter of the nations tracked in the Bloomberg EM USD Aggregate Sovereign Index are trading in distress, generally defined as yields more than 10 percentage points above those on similar maturity Treasuries.

The gauge has tumbled almost 20% this year, already exceeding the full-year loss it notched during the global financial crisis in 2008. Some of that, of course stems from big losses in underlying rate markets, but credit deterioration has been a major driver for the most distressed nations2.

Samy Muaddi, a portfolio manager at T. Rowe Price who helps oversee about $6.2 billion in assets, calls it one of the worst sell-offs for emerging-market debt “arguably in history.”

He points out that many emerging markets rushed to sell overseas bonds during the Covid pandemic when spending needs were high and borrowing costs were low. Now that global developed-market central banks tighten financial conditions, driving capital flows away from emerging markets and leaving them with heavy costs, some of them will be at risk.

“This is an acute period of challenge for many developing countries,” Muaddi said.

Risk aversion has also spread to active traders who are snapping up insurance against default in emerging markets. The cost is lingering just below the peak seen when Russian troops invaded Ukraine earlier this year.

“Things can get worse before they get better,” said Caesar Maasry, head of emerging-market cross-asset strategy at Goldman Sachs Group Inc., in a Bloomberg Intelligence webinar. “It’s late cycle. There’s not a strong recovery to buy into.”

That’s sent foreign money managers marching out of developing economies. They pulled $4 billion out of emerging-market bonds and stocks in June, according to the Institute of International Finance, marking a fourth straight month of outflows as Russia’s invasion of Ukraine and the war’s impact on commodity prices and inflation dragged on investor sentiment.

“This could have really long-term impacts that actually change the way we think about emerging markets, and in particular, emerging markets in a strategic context,” said Gene Podkaminer, head of research at Franklin Templeton Investment Solutions. “The first thing it does is to reaffirm the reputation of emerging markets — they are volatile. There were certainly periods of time when investors perhaps had forgotten that, but it’s hard to ignore that fact now.”

Ballooning bond spreads are also a special concern for central bankers, who are seeing an increasingly stark trade-off between tightening interest rates to protect currencies and damp inflation versus staying accommodative to help keep fragile post-Covid recoveries on track. Multilateral institutions like the International Monetary Fund have also have warned of further on-the-ground strife associated with the burden of soaring costs of living, especially where governments are ill-placed to provide a cushion for households.

A fruit and vegetable vendor waits for customers during a daily power cut at a market in Hikkaduwa, Sri Lanka. Photographer: Rebecca Conway/Getty Images

Sri Lanka’s political turmoil was fanned by sweeping electricity cuts and surging inflation that deepened inequality. That’s something Barclays Plc analysts led by Christian Keller warned could be repeated elsewhere in the second half this year.

“Populations suffering from high food prices and shortages of supplies can be a tinderbox for political instability,” his team wrote in a mid-year report.

El Salvador

The Central American nation’s rating has been slashed by credit assessors as its dollar bonds slumped, driven by the sometimes-unpredictable policies of President Nayib Bukele. The adoption of Bitcoin as legal tender, plus moves by Bukele’s government to consolidate power, has spurred concern about El Salvador’s ability and willingness to stay current on foreign obligations — especially given its wide fiscal deficits and an $800 million bond coming due in January.

Ghana, Tunisia and Egypt 

These nations are among the less-frequent and lower-rated borrowers with low reserve buffers that Moody’s Investors Service warns will be vulnerable to rising borrowing costs. The African sovereigns have relatively low amounts of foreign reserves on hand to cover bond payments coming due through 2026. That could become an issue if they are unable to roll over their maturing notes due to the increased cost of tapping foreign debt markets. Ghana is seeking as much as $1.5 billion from the IMF.

Pakistan

Pakistan just resumed talks with the IMF as it runs thin on dollars for at least $41 billion of debt repayments in the next 12 months and to fund imports. Reminiscent of events in Sri Lanka, protesters have taken to the streets against power cuts of as long as 14 hours that authorities have imposed to conserve fuel. While the finance minister said the nation has averted a default, its debt is trading in distressed levels.

Argentina

The South American nation is lingering in distress after the most recent of its nine defaults, which took place in 2020 during a pandemic-fueled recession. Inflation is expected to top 70% by year-end, adding to pressure on authorities to limit the flight of dollars out of the economy to control the exchange rate. At the same time, a new finance minister and political infighting between President Alberto Fernandez and his Vice President Cristina Fernandez de Kirchner have clouded the outlook for the economy ahead of elections in 2023.

Ukraine

The invasion of Russian troops has led to the exploration of debt restructuring by Ukrainian officials as the war-ravaged country’s funding options are at risk of running out, according to people familiar with the discussions. The nation has also indicated that it needs between $60 billion and $65 billion this year to meet funding requirements, billions more than its allies have so far been able to pledge. Policy makers in Kyiv are struggling to keep the budget running as the military fends off Russia’s invasion, which has destroyed cities, brought the nation’s key grain exports to a standstill, and displaced more than 10 million people. The nation also unveiled a longer-term reconstruction plan that could exceed $750 billion.

© 2022 Bloomberg

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The cascade will turn into an Armageddon later this year.

Global finances have been on edge for a good few years now but no-one really wanted to talk about it because some of them are making too much out of it. US Debt to GDP around 149%, Japan at 230% and then all you need is a lunatic like Putin or Trump plus a few others to tip it over the edge. The First World countries have the back up to get through in banking, infrastructure and productivity but the Third World like SA is clinging on by the fingernails – refer Sri Lanka. And of course we have our own albatross hanging around our necks in the form of the ANC.

We all see these historically sound structures like the Eiffel Tower and expect them to just go on and on, while actually it was only expected to be there for 20 years. It’s rusting away and needs a complete overhaul but the owners are reluctant to close it down because they’re making a mint out of it.

The analogy works perfectly for the global economy.

A sovereign default, debt jubilee, great reset, or outright bankruptcy are different descriptions of the same thing. Debt defaults come in many shapes and sizes. Some types are politically acceptable and some are not. Countries like Venezuela and Zimbabwe had the power to manipulate or rig elections so they could simply refuse to honor the offshore debt and then print the currency to pay local debts.

This kind of crude solution is unacceptable for voters in “sophisticated” nations. Therefore, first-world nations prefer to default on their debts by means of a process called Financial Repression.

When the interest rate on government debt is kept lower than the rate of inflation, and inflation is allowed to stay above the so-called target rate, a reserve bank is able to confiscate the spending power of savers to pay down government debt. They use the savings of investors to fund the debt jubilee to borrowers, and the government is the largest borrower by far.

To come to the point – The USA itself is currently in the process of defaulting on its debt load. They are able to use financial repression as a means of default because their debt is denominated in local currency. They have the power to basically print the currency to pay the debt to international bondholders. The reserve currency status of the dollar enables this process that collects real wealth from across the globe to finance the American Dream.

The USA is able to borrow money from across the globe, at interest rates determined by the Federal Reserve, to buy products and services from across the globe for the benefit of Americans. The USA sees it as a declaration of war if any sovereign nation stops selling its commodities in terms of dollars and stops buying US bonds with the proceeds. The USA enforces this perceived right to buy real commodities with fake money. This privilege certainly is worth fighting for. That is why the USA is constantly embroiled in a war somewhere.

End of comments.

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