Debt Distress: Can Emerging Markets Withstand Rising Costs?

Sri Lanka is in the midst of a political and economic crisis. Is this the first of many crises in emerging markets?

Sri Lanka was headed for trouble no matter what happened in the broader global economy. It made its existing fiscal problems worse with a large tax cut in 2019 and added to its economic difficulties with a poorly timed fertilizers ban that created a need to import food. The government lost access to the bond market two years ago, then dug itself into an even deeper hole by drawing on limited foreign exchange reserves to pay maturing bonds and taking on a last-ditch loan from the China Development Bank. It should have called the International Monetary Fund (IMF) and sought a restructuring of its bonds back in 2020 or 2021, before it ran out of the reserves it needs to pay for essential imports.

While Sri Lanka is an extreme case, many other countries are poorly positioned to manage the current period of high oil prices and higher dollar interest rates. Vulnerable countries can no longer rely on the international bond market and Chinese lending to make up for a shortage of tax revenue and to help pay for imports of oil and gas. Many of the conditions needed to resolve a balance-of-payments crisis—such as a weaker currency and cuts to subsidies—are particularly painful at a time when shortages of food and fuel are driving up prices globally.

Which countries are most at risk?

Several countries in South Asia and North Africa stand out. Pakistan has many of the same structural weaknesses as Sri Lanka, notably difficulty collecting taxes and limited foreign exchange reserves. Tunisia has more reserves than Pakistan and Sri Lanka but is also struggling to meet its budget without access to international bond financing. Meanwhile, Egypt has been hard hit by higher food prices. Like Tunisia, it had relied on the international bond market to cover a portion of its budget deficit and now faces difficulties borrowing sufficient funds at a reasonable rate. Some of these countries could have been able to muddle through in a more benign global environment but now have little choice but to seek assistance from the IMF.

Certain countries in other regions are also at risk: Ghana is clearly struggling with its large debt load, and Kenya too is in an increasingly uncomfortable position. El Salvador has a bond coming due in early 2023. Argentina is also in trouble again, but for slightly different reasons. It lost access to the bond market back in 2018 and had to restructure in 2020, so it doesn’t have large payments coming due on its external bonds anytime soon. But it is having trouble raising funds domestically, and since it has already borrowed so much from the IMF, it really doesn’t have an obvious way to cover any funding shortfall.

At the same time, not all financial trouble stems from government borrowing and an overhang of public external debt. Turkey is an interesting case. It has one of the lowest levels of public debt of all the Group of Twenty (G20) countries. Yet, it could enter a currency, banking, and debt crisis because President Recep Tayyip Erdogan is determined to keep domestic interest rates low in the face of rising inflation. Turkey has sold so many foreign exchange reserves to prop up its currency over the last few years that it could conceivably default simply because it has run out.

In addition, Russia’s invasion has forced Ukraine to seek a restructuring of its external bonds, as Ukraine needs every penny it gets from the United States and the European Union to cover its budget deficit and support its currency. Russia’s own default last month was a direct result of the sanctions imposed by Group of Seven (G7) countries after its invasion.

How does the situation facing these countries compare with past crises?

Financial history certainly rhymes. Rising U.S. interest rates and a stronger dollar have always created a difficult financial environment for emerging economies, as many can only borrow abroad in foreign currency, and others have historically managed their currency to the dollar. Periods of very high or very low commodity prices also predictably create trouble in some parts of the world, as emerging economies often struggle to borrow externally to offset commodity price volatility. When governments run into severe financial trouble and seek international help, the IMF and other sources of emergency financing are always forced to choose: build a rescue program around continued payment of existing debts on their original terms or around renegotiating the payment schedule with creditors.

That said, there is one important difference from the past: the governments of the biggest and most economically important emerging economies, such as Brazil, India, Indonesia, and Mexico, generally haven’t borrowed a lot in foreign currency and now hold enough foreign exchange reserves to manage their external debt load. In fact, the limited external borrowing needs of the bigger and safer emerging economies helped create the global environment that got many of the smaller emerging economies into trouble. The limited supply of foreign currency bonds from some of the bigger names increased the willingness of yield-seeking investors to buy riskier bonds from smaller issuers that are new to the international bond market.

What role has China played in some of these looming debt crises?

After the global financial crisis, China ramped up lending to a host of low- and middle-income countries through its policy banks, the Export-Import Bank of China and the China Development Bank. This began under a policy supporting Chinese firms “going out” into the global economy and then became part of China’s Belt and Road Initiative. Chinese policy lending slowed after the COVID-19 shock, but at its peak, it rivaled lending from the World Bank and the regional development banks in scale.

Unfortunately, China’s lending [PDF] is unusually difficult to track. Its two main lenders don’t self-report their existing exposure by country, and they have at times insisted on limited disclosure by their borrowers as well. Moreover, Chinese banks often lent to support individual projects, such as a hydroelectric dam or a port, that were structured to be outside of formal reporting of government debts.

Despite the difficulties tracking the full scope of China’s lending, its policy banks clearly have lent most heavily to countries with strategic resources (Angola, Ecuador, and Zambia) or with a strategic location (Laos, Pakistan, and Sri Lanka). Chinese lending has generally been on commercial rather than concessional terms; it has not been intended as aid. Furthermore, Chinese banks don’t have a history of taking losses on their external lending, which can make debt workouts more difficult.

This is sure to be a problem in Sri Lanka. The structure of its debt to China is complicated: the central bank has borrowed from the China Development Bank, the finance ministry is directly on the hook to China's Export-Import Bank for some projects, and there are other loans for specific infrastructure projects that won’t be repaid directly by the Ministry of Finance but still drain Sri Lanka’s (nonexistent) foreign exchange reserves. All this lending sums up to around $7 billion—a bit more than the roughly $5 billion that the government formally owes to Chinese banks. Meanwhile, the structure of the $12 billion that Sri Lanka owes on its international bonds is much simpler, because all the bonds are on the books of the Ministry of Finance.

Consequently, Sri Lanka is a real test case. It owes substantial sums to pretty much everyone, the structure of its borrowing from China embodies all of the complexity of China’s policy lending, and it needs debt reduction or concessional interest rates, not just a payment deferral.

What role can multilateral institutions such as the IMF play?

The IMF has an essential role to play. While its capacity to provide concessional (zero-interest-rate) financing to very poor countries is limited, the IMF received a large infusion of funds after the global financial crisis, and it has plenty of conventional emergency-lending capacity. Critically, the IMF is able to lend when other responsible creditors cannot because of its “preferred” creditor status, meaning it gets repaid even when other creditors don’t. It thus is uniquely able to back financial rescue programs for deeply troubled countries.

In cases of distress, the IMF always has to judge whether an external debt restructuring­­­—on bonds, Chinese policy loans, or other sources of credit—is essential to a country’s financial rehabilitation program. In some cases, the decision is easy. Sri Lanka and Zambia are already in default and obviously need to restructure. In other cases, the decision is harder, as countries seeking IMF financing often want to continue making payments rather than seek a preemptive restructuring. Allowing a country to draw down its reserves to make payments can work when the sums involved are small; preserving a country’s reputation for payment can make a subsequent return to market borrowing easier. But if the IMF allows a borrowing country to draw down its reserves to repay existing debts, it puts the IMF at greater financial risk in the future, and it is a mistake if the country already has a debt overhang.

It also seems increasingly likely that the IMF will have to play a more active role in setting out the parameters of how it expects a borrowing country to seek restructuring from each group of creditors. It will then be more willing to lend even when there is a default that hasn’t been resolved through negotiations. This would be helpful when there is a need to marshal financial contributions from a diverse array of creditors, and when there aren’t well-established precedents for who should contribute or how losses should be apportioned.

In the past, bond creditors have been willing to reduce the face value of their bonds while also wanting to maintain relatively high interest payments. Conversely, government lenders often want to maintain the face value of their claims, even if that means accepting very low interest payments. Chinese policy lenders don’t have much experience cooperating with each other, let alone creditors from other countries. “China” is actually a set of distinct, albeit all state-owned, financial institutions that have different interests and often slightly different forms of exposure to a given country.    

What should observers watch for in the weeks ahead?

Three things. The first is whether Ukraine can reach agreement with its bond holders to defer near-term payments and avoid a formal default. It just requested a standstill and has lined up support from some important bond holders, but securing a formal agreement would still be an accomplishment. There isn’t much precedent for these kinds of agreements among bondholders.

The second is whether Zambia will be able to formalize restructuring terms with either the Chinese banks or its bondholders. After a long set of delays, it looks like Zambia is close to reaching agreement with China’s Export-Import Bank, which is considered a government-to-government bilateral lender and is negotiating alongside the traditional Paris Club group of creditors. Any agreement could create a template for Chinese participation in other debt-relief cases.

Third, watch how many of the countries now negotiating for additional IMF financing will be required to seek a restructuring of payments on their existing bonds or their existing loans from China. The IMF’s lending policy will be the single most important determinant of how many countries join the current wave of bond restructurings.