Which countries are at high risk of debt distress?
By Raphaël Cecchi, Senior country risk analyst, Credendo
The analysis and opinion in this article is that of Credendo and its analysts and the views expressed are not necessarily those of WTW.
The liquidity position of some emerging markets continues to be under severe pressure, although sovereign debt markets continue to distinguish between countries based on fundamentals. Countries presenting a high public debt-to-public revenue ratio and a high public interest payments-to-public revenue ratio are more vulnerable. By these measures, Laos and Pakistan are at particular risk of default. Recent crises have also highlighted the relationship between sovereign risk and balance of payments crises; hence high sovereign risk can contribute to high liquidity risk.
In the longer term, debt vulnerabilities may center around climate change. The key risk is a self-reinforcing cycle between sovereign debt vulnerabilities and climate shocks – especially repeated shocks that occur before a country has been able to regain debt sustainability. Reform of the international debt and financial architecture is both likely and necessary to address this issue.
Looking ahead, tighter global financial conditions (including higher interest burdens and lower access to capital markets), coupled with lower global growth prospects, might further increase debt sustainability risks in the most vulnerable countries. Even without a debt crisis, net capital flows to emerging markets with weak fundamentals are expected to remain subdued, putting pressure on exchange rates and gross foreign exchange reserves and reducing countries’ access to international capital markets. These conditions might affect the rollover rate of existing debt as well as issuances of new debt.
As a result, the liquidity position of some emerging markets (e.g. Argentina, Bolivia, Egypt, Ghana, Sri Lanka and Pakistan – see the graph below showing the evolution of foreign exchange reserves since January 2020) continues to be under severe pressure, highlighting the effect of the deterioration of financial conditions and worsening macroeconomic fundamentals on their external liquidity buffers.
That being said, there are large discrepancies between countries and the market has so far distinguished between countries with and without sound fundamentals.
The most vulnerable countries are those presenting a high public debt-to-public revenue ratio and a high public interest payments-to-public revenue ratio. Among them, Ghana, Malawi, Sri Lanka, Zambia and Suriname are in default. Currently, Ethiopia and Ghana are discussing a debt restructuring under the Common Framework whereas Sri Lanka is negotiating a similar outcome with its private and official creditors. In addition, the risk of default in Laos and Pakistan is very high, as highlighted by their MLT (medium and long-term) political risk levels, currently classified in Credendo’s highest category of 7/7.
Alongside developing countries, developed economies can have very high public debt-to-revenue ratios, such as Japan and Singapore. However, the risk is more limited for such countries as they usually have public debt with a long maturity and lower interest rate (indeed, interest rates for such countries are – at least as of this writing – so low that no developed countries appear in the second graph, which is sorted by the interest payments-to-revenue ratio).
Total reserves excluding Gold (in USD)
Source: IMF
Recent sovereign defaults (e.g. Sri Lanka in 2022, Lebanon 2021–22) have highlighted the close relationship between sovereign default and risk of a balance of payments crisis. After all, a sovereign default driven by poor public finances (e.g. Sri Lanka) could rapidly lead to a balance of payments crisis – sharp depreciation in the exchange rate* and depletion of the gross foreign exchange reserves – amid notably large capital outflows.
What’s more, even without a default, very weak public finances can have spillover effects on the economy by triggering capital outflows (e.g. Egypt), making new financing more difficult and expensive to attract, even for the private sector. Moreover, it is very likely that the authorities will have to consolidate their public finances by reducing their spending (e.g. lower subsidies) and/or increasing revenues (e.g. higher taxes) and implementing structural reforms.
Such forced consolidation of public finances can have a lingering impact on economic performance, as well as political stability, further complicating the economic rebalancing process and return to a more sustainable level of public debt (for more on these topics, see the accompanying essay, “How will the debt crisis impact countries’ political stability?”). Last but not least, a high public debt burden implies that the authorities have less fiscal space to implement expansionary fiscal policies, particularly in case of external shocks. This diminished room for manoeuvre reduces growth prospects and makes a country more vulnerable to unexpected external shocks, such as the recent tragic events in Israel for tourism-dependent economies in North Africa and the Middle East.
Another aspect to take into consideration is the growing impact of climate change, which could lead to a rising call for debt service suspension for countries hit by extreme natural disasters. This option has already been used via “hurricane clauses” in bonds issued by Barbados and Grenada. Recently the UN proposed a debt service suspension for Pakistan after the devastating floods in 2022.
This proposal, even if not implemented, reflects the likelihood that in a world of increasingly acute climate change impacts, more countries will face debt service difficulties following extreme natural disasters. The key risk is that the rising frequency and intensity of extreme climate shocks could prevent a full economic, financial and physical recovery from taking place before a country is hit by a new severe natural disaster, leaving it in persistently poor economic conditions and unsustainable levels of public indebtedness.
Moreover, the colossal investment needed to mitigate and adapt to systemic climate change will weigh heavily on debt positions in developing and emerging countries. Therefore, the call for debt service suspension and also climate change-related debt relief will become increasingly resounding over the years, especially in Africa. Such issues are currently hotly debated, making reform of the international debt and financial architecture inevitable in the future.
* Major exchange rate depreciation could lead to high inflation pressures and hence to the need for monetary tightening at a time where the economy is already under stress.
