Is peak emerging market debt distress in the past?

Summary

In mid-2022, we published a series of reports focused on sovereign default risks in the emerging and frontier markets. Takeaways included how tighter monetary policy, a strong dollar and global economic malaise were weighing on developing nation's ability to service sovereign debt obligations. During the middle of 2022, we believed credit rating downgrades and a wave of sovereign defaults were likely to materialize. While sovereign stresses indeed mounted over the course of 2022 and 2023, we now believe the most challenging period for emerging and frontier market sovereigns is over as sovereign debt profiles and asset positions have improved. Going forward, should our outlook for central bank policy rate cuts and a weaker dollar come to fruition, sovereign default risks could ease more substantially over time.

Emerging market sovereign default risks are receding

Not long ago, the global economic backdrop offered serious challenges for emerging market countries. Dynamics surrounding monetary policy, financial markets, global economic growth and politics were less than ideal for stability in the developing world. Which is likely why—combined with economic mismanagement at the local level—so many emerging and frontier governments experienced sovereign debt repayment issues over the course of 2022 and into 2023. In fact, during the summer months of 2022, we published a series of reports focusing on sovereign debt dynamics in emerging markets. We pointed out how debt servicing costs had risen considerably despite overall debt burdens being lower relative to advanced economies. We also highlighted that an elevated number of governments across the emerging markets had debt trading at distressed levels, and probabilities of sovereign default and credit rating downgrades were elevated. We even went so far as to identify which countries were at risk of default in the near future as a difficult global landscape was likely to persist for the time being. Fast-forward to 2024 and the problems that once weighed on emerging sovereign repayment capacity have not completely disappeared but, in our view, have subsided. Central banks around the world, in particular the Federal Reserve, have ended tightening cycles and are approaching interest rate cuts. The U.S. dollar, while still strong relative to historical levels, has broadly slowed its pace of appreciation and is off recent highs. Global growth has been resilient, and the political and social volatility that spawned from cost of living pressures has also cooled. While the global economy is not without challenges and uncertainties, we believe the global landscape has evolved in a way where emerging market sovereign default risks have come down and the most challenging post-COVID period for widespread sovereign stress in the developing world is in the past.

In August 2022, when the global backdrop was arguably most concerning for emerging markets, we developed a framework to identify sovereigns potentially at risk of default. In 2022, our analysis was useful to highlight at-risk sovereigns, some of which did ultimately miss debt payments, but also nations likely to experience crisis conditions in the near future. We recently updated this framework not only to get a sense for country-specific default risks, but also to discern the overall direction of sovereign stress. As mentioned, we believe the direction of sovereign credit risk is on an improving trajectory, a view supported by our analysis of the global economy but also revealed by our sovereign default framework. Our framework is built around four indicators that we believe appropriately capture debt repayment capacity. These indicators are centered around the sovereign debt profile as well as components of the sovereign's asset position, and include:

• Gross Government Debt (% of GDP)

• Interest Expense (% of government revenue)

• Foreign Currency Denominated Debt (% of total outstanding sovereign debt)

• Foreign Exchange Reserves (months of import coverage)

We selected these metrics to assess the size and cost of sovereign debt burdens, the currency composition—local currency vs. foreign currency—of government debt to ascertain sensitivity to dollar strength, as well as liquid reserve assets that can be used to service coupon payments or make maturity payments. As far as the methodology for our framework, we use a scorecard approach to aggregate these variables and determine an overall level of sovereign default sensitivity. Our framework incorporates IMF forecasts for each indicator. We then use IMF projections to create a rolling 12-month forecast to ensure a forward-looking view of the evolution of sovereign debt profiles and asset positions, rather than where these metrics stand today. We also selected a very specific universe of countries to analyze. Our framework is designed to capture the more systemically important emerging market nations—such as China—as well as some of the largest and most liquid frontier nations, such as Nigeria. While frontier economies may not be systemically important the same way countries like China are, should one or more frontier sovereigns in our universe default, financial markets could be briefly rattled. And finally, we excluded sovereigns that are currently in default, such as Zambia and Sri Lanka. While these sovereigns would flash as highly at risk, we left these countries out of our universe in an effort to identify only new sovereign default candidates.

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