Unpacking the hidden costs of sovereign debt burdens in emerging markets

Building upon the previous analysis of debt burdens in highly developed countries, this final article in the mini-series seeks to move beyond them and look at the rest of the world.

At first glance, debt levels among developing and ‘emerging market’ (EM) nations (as they are often called), may seem more stable. For example, debt burdens among EMs are around 70% of GDP, substantially lower than in highly developed countries. While we were concerned about the volume of debt issued by Western nations, here concern lies about the instruments many EM economies must use to finance their debts. 

The key point is that emerging market nations do not fully control their own monetary conditions. EMs and developing nations have long been considered riskier borrowers by bond markets because they lack strong institutional credibility. Fitch, a credit rating agency, considers bonds to be of “investment grade” if they have a credit rating of BBB- or higher: a standard met by only four countries in Africa. Bonds with lower credit ratings are sometimes called “junk” bonds, and as the name implies, these are considered unattractive to potential buyers. To compensate for the increased possibility of non-repayment, investors demand a risk premium – essentially a higher yield on government bonds. This increases the cost of financing debt and makes it harder for such economies to take on higher levels of fiscal strain in the first place.

Because they are seen as riskier borrowers, EMs are often forced to issue shorter-maturity bonds. However, these concentrate risk over a condensed span of time, as they require near-constant refinancing, leaving governments at the whim of the bond market. If markets panic, then governments can have astronomically high yields forced on them. In 1998, Russia began issuing bonds with maturities of less than a year, and fears of currency devaluation led to the Russian government offering increasingly higher yields (up to 100%, or the original price of the bond) to finance and refinance short-term debt. The consequence was predictable: on 17 August 1998, the Russian government defaulted on its debt and was forced to devalue the ruble overnight by around 33%. In the first instance, devaluation seriously hurts domestic living standards (imagine being told the pound in your pocket will only buy 67 pence worth of imported goods tomorrow...), it also sends a negative signal to investors about future repayments, increasing the risk premium demanded. Sustainable access to credit is an essential feature of a modern state, and defaults carry a heavy price.  

It is also worth addressing another elephant in the room: the world’s largest monetary superpower. The country in question is, of course, the United States. When the U.S. Federal Reserve tightens monetary policy (i.e. reduces the availability of money and credit), U.S. assets become relatively more attractive and this is often accompanied by large capital or “hot money” outflows and falling EM asset prices. Not only does this hurt EM financial markets by lowering equity prices, it implies bond yields spiking. This is because the price of bonds falls due to the aforementioned outflows, thereby requiring governments to sell more (and pay the associated interest) to issue the same amount of debt. This in turn puts pressure on that country’s fiscal situation. The consequence of this is that when the Fed is pursuing contractionary monetary policy, EM central banks will often try to pre-empt them by tightening first, encouraging investors to keep their assets in the country by offering higher returns, thereby shoring up their own currency. In 2024, the Bank of Indonesia undertook several rate increases with the explicitly stated goal of supporting the rupiah. However, this might run counter to other macroeconomic goals by restricting domestic access to credit, artificially keeping the economy below its output potential and constraining the economic growth that many EM countries so desperately need.  

The problems outlined above unfortunately have no easy fixes. If EM nations were able to issue more long-maturity denominated in their own currency, then they would be far less at the mercy of international bond markets. However, this would require a domestic investor base, and levels of domestic saving, that are not currently present but may arise naturally as a result of rising incomes. For some countries, institutional credibility (most importantly, central bank independence) would also help. However, it is probably not possible to develop those to the level of western nations without stable democratic systems.  

Debt burdens are probably not the biggest problem facing emerging market economies in the coming years. However, in an increasingly unstable world, the inflexibility of monetary policy may yet become a salient issue.

The views and opinions expressed in this article belong solely to the writer and do not necessarily reflect the views and opinions of the Warwick Economics Summit.

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