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Factum Special Analysis: Emerging Markets and International Sovereign Bonds
By Kasun Thilina Kariyawasam
A total of USD 1,737.2 billion has been invested in the sovereign debt of emerging markets over the last 12 years. As a result of the high interest rates, emerging markets (EMs) paid 63% of the total interest on the bonds. Since 2020, Argentina, Zambia, and Sri Lanka have defaulted on their bond repayments due to socio-economic turbulence. According to current analyses, six countries, including Ghana and the United States, all face similar challenges to service their debts.
Through international bonds, the global capital market has naturally cornered emerging markets into the trap of high debt risk. Emerging markets have become victims of high debt risk because financial institutions encouraged them to issue more bonds when commodity prices were high.
Today, as a result of the economic downturn and the increased interest rates of the US dollar, these countries are facing multiple challenges.
In the aftermath of the 2008 global financial crisis, this trend was particularly evident, with the stock of International Sovereign Bonds of all low and emerging markets rising from USD 484.3 billion in 2009 to USD 1,737.2 billion in 2020. In low and EM countries, International Sovereign Bonds accounted for 50.4% of government-guaranteed external debt in 2020, up from 30.7% in 2009.
The share of traditional bilateral and multilateral loans in the overall debt of emerging markets has decreased. Since 2009, the stocks of International Sovereign Bonds issued by sub-Saharan African countries have quadrupled to USD 136.6 billion. During the same period, African countries’ bilateral debt has only doubled, amounting to USD 114.9 billion in 2020, and similar phenomena have been observed elsewhere. Furthermore, African countries have issued 10-year Eurobonds at coupon rates ranging from 4% to 10% in 2013-2019, compared to bilateral and multilateral debt at much lower rates.
The financial costs of international bond debt service account for a larger percentage of the debt service cost for these countries due to the generally high interest rates on international bonds. In 2020, EMs paid 63.2% of their total interest payments on international bonds while only paying 9.8% on bilateral debt. Emerging markets that issue bonds should be aware of how rising bond stocks and high financial outlays affect them.
Thanks to a combination of external factors, such as severe fiscal deficits, falling commodity prices, declining international demand, and the COVID-19 epidemic, EMs have been facing steadily increasing debt pressure since 2016.
While underestimating the impact of international bonds on sovereign debts, international attention has focused largely on non-Western emerging lenders, like China, and presented unfounded arguments like “debt traps”. In the coming years, EMs will have a higher external debt burden due to the peak of international bond repayments and volatility in capital markets caused by the new cycle of US dollar interest rate hikes.
However, International Sovereign Bonds have certain advantages for developing nations, which is why they tend to rely on the bond market for their capital needs. International Sovereign Bond issues are a straightforward process that can be initiated relatively easily. In emerging markets, capital fluctuations are unpredictable due to high levels of friction. Their trajectory cannot be accurately predicted. In such cases, ISBs can be used as a tool for borrowing.
Providing benchmarking for private bonds in a growing economy will enable private firms to advance rapidly. As a result of building trust and a reputation among international investors, the government has created a condition for large-scale mobilization operations in the coming years that will work in the government’s favor.
Investors have a huge appetite for International Sovereign Bonds. Emerging market bonds are often part of most portfolios since their rates are relatively high and their risks are relatively low. As a result, investors have a large appetite for emerging market International Sovereign Bonds.
It is because of two major reasons that International Sovereign Bonds caused more externalities than advantages to emerging markets. The first is that most EMs failed to set up a synchronized industrial plan to guide their economy.
Because of this, it tends to have a fragmented asset allocation. In addition to creating friction in the economic flow, fragmented asset allocation also creates market dissension. EMs are unable to digest external shocks of the global economy. Most EMs do not have macroeconomic prudential mechanisms to safeguard their economies. As a result, they are extremely vulnerable to external shocks.
The case of Sri Lanka
Sri Lanka’s economy revolves around plantations. Its major crops are tea, rubber, coconuts, and rice. The country has a weak industrial base, but agriculture and garment manufacturing are important industries. The economic growth impetus in Sri Lanka is insufficient due to its low level of technological development.
During the period 2013-2019, its GDP growth rates hovered between 2%-4%, which was lower than those of its neighbors in South Asia. Its foreign exchange income is mainly derived from exports of primary products, remittances from immigrants, and tourism, and its exports fluctuate widely.
For many years, Sri Lanka’s exports stagnated and sometimes registered negative growth, leaving it in a trade deficit. As a result, Sri Lanka’s foreign exchange reserves declined as well. Upon taking office in November 2019, the country’s foreign reserves decreased from USD 7.5 billion to USD 5 billion, then USD 2 billion at the beginning of 2022, which could only cover import expenditures for the next few months. In the meantime, the public budget deficit has been increasing.
Social welfare subsidy policies have long been implemented in Sri Lanka, causing great expenditure pressures that can only be alleviated by long-term borrowing. Between 2007 and 2017, Sri Lanka’s overall budget deficit increased by 160%, and its total debt owed to the government increased by 209%, according to the World Bank.
Due to a lack of investment income and a high interest rate on its commercial loans, Sri Lanka has been in a debt crisis in recent years. There was a 605% increase in Sri Lanka’s non-project loans from 2007 to 2017, but only an 117% increase in its project loans. The principal and interest on non-project loans increased too fast, and they could not generate enough income to repay them.
Moreover, the proportion of multilateral and bilateral preferential loans in Sri Lanka’s external debt has declined rapidly since the issuance of International Sovereign Bonds in 2007. The government was forced to borrow new debt to repay the existing debt in a short period of time, resulting in a 42.98% share of the total debt, with an average interest rate of 6.29%.
The coupon rate on Sri Lanka’s international bonds increased to 7.85% in 2019 after issuing 14 bonds between 2017 and 2019. Sri Lanka became particularly vulnerable to a refinancing crisis due to a strong dollar and a recovery of capital markets in developed countries. As of 2021, Sri Lanka’s external debt represents 119% of its GDP, up from 42% in 2019.
The ratio of foreign exchange reserves to foreign debt has declined from 24.2% in 2011 to 5.48% in 2021, indicating that Sri Lanka’s foreign exchange reserves will face serious challenges.
The two peak periods of foreign debt repayment in Sri Lanka are 2019-2022 and 2025-2027, causing future emergencies. Sri Lanka’s economy was severely affected by the COVID-19 pandemic and the Russia-Ukraine conflict. As a first step, Sri Lanka’s GDP used to be over a tenth of tourism.
Tourism in Sri Lanka earned USD 4.4 billion in 2018 and contributed 5.6% to GDP, but due to the pandemic, the figure fell to 0.8% in 2018. Statistical data from the Sri Lankan Tourism Development Authority’s Monthly Tourism Arrivals Report for February 2022 indicates Russians and Ukrainians are Sri Lanka’s top two tourist sources. Sri Lanka received nearly 28,000 tourists from Russia and 13,062 tourists from Ukraine in the first two months of 2022.
As a result of the Russia-Ukraine conflict, the number of tourists from the two countries has declined dramatically. Because Russia is Sri Lanka’s largest tea importer, the conflict also affects the tea exports, another source of foreign exchange reserves. Due to the Western sanctions, the ruble collapsed, making it difficult for Russians to continue importing Sri Lankan tea.
Moreover, global commodity prices surged as a result of the pandemic and the Russia-Ukraine conflict, leading to a surge in crude oil and food prices in Sri Lanka, where supplies are short. The national inflation rate climbed to 17.5% by March 2022, and foreign exchange reserves dropped to USD 1.9 billion. Eurobonds maturing in 2022 made repayment of the dollar debt due in 2022 almost impossible. In this situation, Sri Lanka announced on April 12, 2022 that it would default on its external debt, its first debt default since independence.
There has been no successful industrial transformation in Sri Lanka, and no new sources of income generation at home or abroad have been found either. The country instead issued large amounts of commercial bonds, which resulted in a fiscal deficit and led to a dilemma of borrowing new debt to repay old debt with rising interest rates.
Due to the pandemic, the Russia-Ukraine conflict, and international financial fluctuations, the Sri Lankan economy was overburdened and collapsed rapidly. Sri Lanka’s painful lessons should be learnt by other developing countries.
Problems with International Sovereign Bonds 
It is true that developing countries need funding due to expansionary fiscal policies. Due to the ease of issuance of International Sovereign Bonds on the international financial market, they reduced the proportion of bilateral and multilateral preferential loans with low interest rates and long repayment cycles. However, institutional investors from advanced economies are enthusiastic about bonds issued by developing countries completely independent of their own commercial interests.
Their operations mainly follow the practices of mature markets in the world, which satisfy the needs of investors to obtain high returns in the short term, but neglect the fragility of economic structures and the specificity of long-term development of developing countries.
There are three systematic risks associated with commercial international bonds for developing countries that need to be addressed in order to avoid further expansion of debt default crises and more serious consequences for global development. They call for special attention and improvement measures to be taken as soon as possible.
Sovereign Bonds are procyclical 
Pricing, subscriptions, and ratings of Western financial institutions tend to fluctuate within certain parameters during an economic cycle. In other words, they are procyclical. Developing countries that rely mainly on mineral and energy export are in a period of economic prosperity in times of high global liquidity and commercial prices, so they are more likely to issue International Sovereign Bonds and have high ratings, while the cost of issuing bonds is relatively low. In the event of a global recession and declining resource prices, these countries may need to borrow more to maintain economic stability, but at this point, rating agencies would downgrade their credit ratings.
In the meantime, new bonds require higher coupon rates and lower issuance prices to attract investors, which exacerbates the problem. It is true that developed countries also face similar superimposed market fluctuations, but developing countries have fewer revenue sources and smaller economic volumes, so they are more likely to experience a crisis or default.
Furthermore, ISB are mainly denominated in the US dollar. Thus, when the dollar’s liquidity is loose and the exchange rate is low, ISB can be issued easily. However, when the US dollar’s interest rate rises and its exchange rate rises, a large amount of funds flow out of developing countries. During a period of tight liquidity, bond-issuing countries are forced to borrow money and repay debts at high interest rates and exchange rates.
The role of ratings agencies
On the global lending market, S&P, Moody’s, and Fitch Ratings control 95% of the market share. It is primarily through the analysis of macroeconomic, fiscal, and external risks that the three institutions assign a sovereign credit rating to a country.
Due to their weak economic indicators, developing countries generally have low sovereign ratings based on the current rating framework of the three institutions. As a result of low financial risk bearing capacity, developing countries’ administrative mechanisms are not as mature and sound as those of developed countries. From 2000 to 2009, a study examined the macroeconomic data and the average sovereign credit ratings assigned by the three major rating agencies in 60 countries.
According to the study, GDP per capita, inflation, savings/investments, and gross government liabilities have significant impacts on sovereign credit ratings. While deficits, current account balances, foreign exchange reserves, and foreign debt are among the main factors influencing sovereign credit ratings in developing countries. According to this study, the sovereign credit ratings of developing countries are more likely to be affected by short-term factors than those of developed countries, and they also change more frequently as a result.
Due to fiscal optimism, good exchange rate performance, economic growth, and other factors, developing countries have high sovereign credit ratings when they issue bonds. However, if sudden external risks occur during the repayment of debt, they may be downgraded and may experience a debt crisis. Low-income countries applying for debt suspension or relief from creditor countries to cover the new public health expenditures suffered a great blow to their sovereign credit ratings as a result of the COVID-19.
Several times after Ethiopia applied for debt restructuring with the G20 to combat the COVID-19 pandemic, S&P, Moody’s, and Fitch lowered its ratings. Ethiopia’s sovereign credit rating was lowered from “B” to “CCC” by S&P; Moody’s from “B2” to “Caa2” by Moody’s; and Fitch’s from “B” to “CCC” by Fitch. Debt sustainability was severely challenged as the overall debt risk rose sharply.
The mismatch between developmental rhythms and ISBs
In addition to its short-term orientation, ISBs also have a concentrated maturity. It usually takes a long time for infrastructure construction and production projects to be completed in EMs. There are some that take more than 10 years to yield benefits, and revenue is hard to predict. Bond-issuing countries are therefore forced to find other valuable foreign exchange or issue bonds with higher interest rates to repay their maturing debts, further squeezing liquidity and disrupting normal economic activity.
In the event that the issuing country cannot repay the matured debt, it will default, and its future financing will become extremely difficult. International financial capital is generally based on the mature economic activities of EMs and isn’t flexible and tolerant enough of the liquidity challenges they face. Market factors such as low ratings and high risks contribute to the short maturity of ISBs issued by developing countries compared to bilateral or multilateral loans from governments, multilateral banks, and international organizations.
As a result of the large stock of commercial bonds in EMs, debt servicing costs have increased and financial sustainability has decreased. The reduction of available liquidity poses a particular threat to macroeconomic stability. A debtor country that cannot refinance at the peak of debt repayment will have to spend a large amount of foreign exchange reserves to repay the debt, leading to a sudden reduction in public expenditure and devastating consequences for national development.
When government expenditures are suddenly reduced, infrastructure constructions and public projects stagnate and cannot recover existing investments; the government’s means of stimulating economic growth are further limited, the overall social output decreases, and the unemployment rate increases; the normal economic order is severely disturbed, and bankruptcy and default spread.
It is likely that the sudden reduction in public expenditure caused by the debt repayment peak and the difficulty in refinancing will end the economic structural transformation efforts of emerging countries that need to develop infrastructure urgently and lack a sound industrial system.
After the liquidity crisis, it will take a long time to recover precrisis results. It has already caused several developing countries, including Argentina and Ecuador, to fall into the vicious cycle of unsustainable economic growth.
ISB funds are not restricted, and they can be used for nonproductive expenditures. Investors don’t care about how funds are used. Investment risk is only measured by the macroeconomic situation of the country and they seek to profit from high prices and high interest rates without paying attention to how the funds are used.
As a result of such freedom, bonds can be used for filling fiscal gaps or for funding short-term political goals in developing countries with unstable political and economic conditions. The result is that people “live beyond their means” while neglecting investment in productive and profitable projects, leading to an unsustainable long-term economy. Sri Lanka is a classic example. Between 2015 and 2019, the country issued USD 12 billion without any growth plans.
Policy recommendations
For all these reasons, EMs should be extremely cautious when issuing ISBs. Countries should issue ISBs in order to complete their well-planned investments. The government should seek out more bilateral lending options for long-term investments
Sri Lanka and Suriname are countries with high levels of ISB exposure. Such countries should maintain a stable socioeconomic environment, as bond markets are highly sensitive to such events. They should diversify their ISB baskets by creating synced developmental projects that are properly forecast along with debt servicing timelines to spark a virtuous cycle.
An economy will be more vulnerable to foreign currency fluctuations if it relies too heavily on the US dollar. A bottom-to-top approach should be followed to address such issues. It is also critical for countries to diversify their industrial exports and imports. It is equally critical to encourage firms to expand into other countries. Cross-border settlement corridors should be built between such diversified nations. Countries must implement better capital controls to manage their inflows.
Kasun Thilina Kariyawasam is a macroeconomist who works for the fund management sector in Sweden. He can be reached at kasunkt@hotmail.com.
Factum is an Asia Pacific-focused think tank on International Relations, Tech Cooperation and Strategic Communications accessible via www.factum.lk.
The views expressed here are the author’s own and do not necessarily reflect the organization’s.
 


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