Page 19 - bne monthly magazine October 2022

bne October 2022 Companies & Markets I 19
at governments already in a weakened position. Debt-to-GDP ratios have risen inexorably after 2010.
“We focus on the 80+ sovereigns with sovereign bonds outstanding. The profile of the 75th percentile of the debt-to- GDP distribution is a good place to look for risks of widening stress; it increased dramatically, from 45% in 2010 to 68% in 2019. And then it rocketed to 83% after the COVID-crisis and supply shocks,” says Sterne.
And the first defaults are already appearing, including Russia, Sri Lanka, Ukraine and Zambia, which is a 20-year high, but still below the defaults that followed the stagflation episode in the 1970s and that went on to cause financial crises in the 1980s.
The situation is even worse than this data suggests, Sterne argues, as defaults come at the end of a period of distress, but the prices on the bonds are forward looking and the price of EM debt has already jumped to 25-year highs, with the dollar-
“EM debt has already jumped
to 25-year highs, with the dollardenominated debt of around 25 EM sovereigns trading at yields of more than 1,000 bps since the start of this year”
denominated debt of around 25 EM sovereigns trading at yields of more than 1,000 bps since the start of this year.
The 1980s experience reveals how defaults can come in waves triggered by a terms-of-trade shock. Most commodity producers defaulted at least once during that period, Oxford Economics reports.
“This time the impact is less focused on any particular group of economies. Commodity importers have suffered the biggest negative terms-of-trade shock, but all EMs suffered under Covid and generalised struggles in the global economy, includ- ing the fallout from Russia's war on Ukraine,” says Sterne.
Composition matters
No one likes to restructure their debt, but how that debt up is made affects their ability to do restructuring deals if forced to.
Holders of local currency assets are typically a soft target for debt reduction for governments. A currency depreciation immediately cuts debt but typically causes high inflation. Capital controls also allow a government to impose negative real interest rates on local currency instruments, which also reduces debt. The bigger the share of local currency debt in the total debt, the bigger the incentive to depreciate rather than default on FX debt.
The good news for holders of sovereign bonds that are denominated in foreign exchange is that most mature EMs have largely issued debt in local currency, a process facilitated by Clearstream that has been connecting local debt markets to the international system, allowing traders in London and New York to participate directly on exchanges in places like Moscow or Kyiv. The dramatic shift came between 2004 and 2012, when the average share of local currency issues in total external sovereign debt in larger EMs increased dramatically, to 60% from 15% reports Oxford Economics. For example, Brazil, China and India's total issues of dollar-sovereign bonds each amount to less than 5% of GDP, so it will likely never be worthwhile for them to default.
Smaller, less mature frontier markets have not connected their markets to the international system, making it oner- ous for international investors to tap their bond markets and leading those countries to have a much larger share of FX obligations. Of the 19 most distressed sovereigns, only four have domestic debt greater than 60% of the total. Sovereign spreads of these four are nevertheless temptingly high (Egypt >900bps, Nigeria >780bps, Pakistan >1200bps and Argentina >2400bps), reports Oxford Economics.
“Three of the four have demonstrated a long-standing capac- ity to tap local markets for funding (Argentina is a more complex story), and there may be a case to argue markets are underestimating the role of domestic funding in shielding dollar-debt from default,” says Sterne. “A big risk for all four is that domestic funding pressures result in pressures on the current account. For them, fiscal stress would most likely transmit to crisis via a pressure on currency and the result- ing drain in FX reserves (though only Argentina and Nigeria currently have very low reserves).”
But most of the counties in distress have relatively low levels of domestic debt: Tunisia, Mozambique, Angola, Tajikistan, El Salvador, Ecuador and Cameroon each has domestic debt under a third of the total. “For these, when debt reduction is needed, attention will go directly to haircuts,” says Sterne.
Spreads of the most distressed sovereigns
bps (log scale)
Source: Oxford Economics / Haver Analytics
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