The Emerging Debt Crisis in Emerging Markets
The Emerging Debt Crisis in
Emerging Markets
The Genesis of Unsustainable Debt
in Emerging Markets:
The total debt in emerging
markets has reached US$72.5 trillion in 2019, which represents a 168% increase
over a 10-year period according to a Bank of International Settlements (BIS)
report. Fixed income investors have flooded into emerging markets as they hunt
for yield in the low-interest rate environment prevalent across the globe. Central
banks have increasingly pursued an asymmetric monetary policy where they
supported markets when they declined but failed to damp down the exuberance
when the markets were prone to bubbles. Central banks have kept interest rates
at low levels over the last decade and while this has led to an influx of
investors into equity markets, it has also made risk-averse investors take
increasingly more risk to earn a positive inflation-adjusted return on their
fixed income investments. Due to the hunger for yield, Eurobond markets have opened
to dozens of poor countries that have historically been unable to access public
debt markets. This easy access to credit led to an unsustainable borrowing
binge by emerging markets.
The Vulnerable Countries:
No country borrows money with the
expectation that it will ever repay the borrowed amount in full. The underlying
assumption driving the borrowings is that when the liabilities fall due, the
countries will be able to borrow from someone else to pay the maturing debts.
This fundamental assumption has permitted both developed and developing countries
to carry debt loads that are unsustainable. However, the coronavirus may
shatter the illusion of comfort created by this assumption.
At least 102 countries have asked
the International Monetary Fund (IMF) for relief since the start of the
pandemic. While some of the countries such as Argentina, Lebanon and Venezuela
were facing difficulties even prior to the beginning of the coronavirus, the
pandemic has put more emerging countries into distressed territory. Bloomberg
defines distressed countries as those with an average bond spread over 1000
basis points relative to U.S Treasuries. Based on this definition the following
countries are in distress:
In general, the virus outbreak
has wreaked havoc on global economies and put significant pressure on national
budgets. Firstly, governments have launched massive stimulus packages to keep
small and large businesses afloat as well as to pay their unemployed citizens
to stay at home. In addition, there has been a large cut in government revenue
as business activity has grinded to a halt. Corporate tax revenue will also decline
drastically over the coming quarters as top lines shrink for companies and
costs surge in the short term due to supply chain disruptions and virus
protection related costs. Income taxes will take a massive hit as unemployment
reaches all-time highs across the world. Sales tax revenue will also reduce as
consumption will decline as people increase their marginal savings due to the
prevailing uncertainty in the economy. The increased pressure on budgets will
make servicing debt difficult for all economies but the coronavirus has a
disproportionately large impact on emerging markets.
Many of the emerging markets are
highly dependent on tourism and the virus has placed the tourism sectors of
many emerging markets in a comatose state. In addition, due to the global
economic slowdown many foreign workers have been forced to return to their
countries due to layoffs and this has led to lower inward foreign remittances.
Furthermore, the global commodity prices have sunk due to the lower economic
activity and this has adversely impacted export revenues, especially of oil
producing countries (which were already under extra pricing pressure due to the
failure of OPEC+ to reach a consensus on output reductions which subsequently
led to a glut in oil supplies). To make
matters even worse, the currencies of these developing countries have
drastically depreciated against the US Dollar due to the flight to safety of
foreign funds. These factors together have resulted in the dwindling of foreign
reserves which has put pressure on the servicing of hard debt.
Under normal circumstances, the
debt would be refinanced but these are not normal circumstances as credit
markets have tightened and spreads have risen. This means that the abundant
cheap capital that was available for emerging markets has dried up. As the
pandemic continues to ravage countries, it is becoming increasingly clear that
this is not just a short-term stress, but it will evolve into a medium to
long-term issue. So, what exactly can be done to avoid the emerging debt
crisis?
First and foremost, the cash flows
of governments must be freed up to deal with the humanitarian crisis. There is
a significant need for short-term cash. This includes increasing spending on healthcare
in the form of increased protective equipment for doctors and nurses on the
front lines and purchasing more ventilators. Moreover, it is critical that
governments increase the bed capacity of hospitals to handle any future spikes
in infections once the lock downs are eased since the development of a vaccine
would not be achieved in the near future.
While some of the immediate
defaults can be avoided by emergency funding from the IMF and World Bank, their
resources would be overwhelmed in a global recession. Instead what is needed in
the immediate short-term is a debt moratorium of 6 – 12 months in order to ease
the cash flow pressure on countries so that they can focus on the curtailing the
ever-mounting health crisis. This standstill mechanism should allow creditors
to assess the long-term economic implications of the pandemic and craft an
appropriate long-term plan.
The long-term plan might include
stricter negative covenants that would help to provide additional protection
for the bondholders. Some such covenants might be minimum benchmarks that have
to be met before additional debt can be taken on. For example, the debt-to-GDP
ratio must first be reduced to a pre-agreed level before new debt can be
issued. Such negative covenants can significantly erode the sovereignty and
independence of emerging markets.
Countries with good repayment
history will garner sympathy from creditors but other countries with reckless
borrowings and poor repayment history such as Argentina (which has defaulted 8
times prior to COVID-19) will be faced with stricter repayment schedules.
Another option that is available
is to restructure the debt by writing them down and converting them into new
instruments with additional credit enhancement facilities. Moreover, the new
instruments could have stabilizing properties such as a GDP-linked and
commodity-price indexed bonds. However, these measures are drastic and would
require a large coordinated effort by the creditors which will be challenging.
The biggest hurdle for a debt
relief program for developing countries is coordinating efforts across various
creditors which includes other countries, sovereign wealth funds and other
institutional investors. Some creditors may be reluctant to suspend repayments
if the money that is saved is diverted to paying other creditors rather than
being used to tackle the coronavirus. The only way to avoid such a scenario is
if all the creditors agree to the same terms of debt relief.
The Future of Emerging Market
Debt
Once the immediate crisis has
been averted, it is time to evaluate the principles underpinning the safety of
sovereign debt. Sovereign debt has always been considered as a safe investment
with a low default risk since the debt is backed by the government’s ability to
collect taxes and print money. However, in times of crisis this is may not be a
viable strategy. The default risk of a bond increases when an economy goes into
a recession. During a recession, the tax revenues decline as unemployment rises
and profits dwindle. The government cannot raise tax rates in such a scenario
without further deepening the recession. Furthermore, if the government decides
to print money it risks creating hyper-inflation in the economy and further
weakening its currency. In the future, yield hunting investors may be extremely
selective about the emerging countries that they invest in and will embark upon
a more stringent due diligence process and run extreme stress tests to evaluate
the safety of their investments.
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