The markets for the bonds of emerging markets have been rattled by developments in Venezuela. On November 13,Standard & Poor’s declared Venezuela to be in default after that country missed interest payments of $200 million on two government bonds. Venezuelan President Nicolás Maduro had pledged to restructure and refinance his country’s $60 billion debt, but there were no concrete proposals offered at a meeting with bondholders. By the end of the week, however, support from Russia and China had allowed the country to make the late payments.
Whether or not Venezuela’s situation can be resolved, the outlook for the sovereign debt of emerging markets and developing economies is worrisome. The incentive to purchase the debt is clear: their recent yields of about 5% and total returns of over 10% have surpassed the returns on similar debt in the advanced economies. The security of those returns seem to be based on strong fundamental condtions: the IMF in its most recent World Economic Outlook has forecast growth rates for emerging market and developing economies of 4.6% in 2017, 4.9% next year and 5% over the medium term.
The Quarterly Review of the Bank for International Settlements last September reviewed the government debt of 23 emerging markets, worth $11.7 trillion. The BIS economists found that much of this debt was denominated in the domestic currency, had maturities comparable to those of the advanced economies, and carried fixed rates. These trends, the BIS economists reported, “..should help strengthen public finance sustainability by reducing currency mismatches and rollover risks.”
It was not surprising, then when earlier this year the Institute for International Finance announced that total debt in developing countries had risen by $3 trillion in the first quarter. But surging markets invariably attract borrowers with less promising prospects. A FT article reported more recent data from Dealogic, which tracks developments in these markets, that shows that governments with junk-bond ratings raised $75 billion in syndicated bonds this calendar year. These bonds represented 40% of the new debt issued in emerging markets. Examples of such debt include the $3 billion bond issue of Bahrain, Tajikistan’s $500 million issue and the $3 billion raised by Ukraine. These bonds offer even higher yields, in part to compensate bondholders for their relative illiquidity.
The prospects for many of these economies are not as promising as the IMF’s aggregate forecast indicates. The IMF’s analysis also pointed out that there is considerable variation in performance across the emerging market and developing economies. The projected high growth forecast for the next several years is based in large part on anticipated growth in India and China, which account for more than 40% of the collective GDP of these nations. Weaker growth is anticipated in Latin America and the Caribbean, sub-Saharan Africa, North Africa and the Middle East.
The IMF also raised concerns about the sustainability of the sovereign debt of these countries in October’s Global Financial Stability Report. In the case of low-income countries, the report’s authors warned: “…this borrowing has been accompanied by an underlying deterioration in debt burdens… Indeed, annual principal and interest repayments (as a percent of GDP or international reserves) have risen above levels observed in regular emerging market economy borrowers.” Similarly, Patrick Njoroge, head of Kenya’s central bank, has warned that some African nations have reached a debt-servicing threshold beyond which they should not borrow.
None of these developments will surprise anyone familiar with the Minsky-Kindleberger model of financial crises. This account of the dynamics of such crises begins with an initial change in the economic environment—called a “displacement”—that changes the outlook for some sector (or nation). The prospect of profitable returns attracts investors. Credit is channelled by banks to the new sector, and the increase in funds may be reinforced by capital inflows.The demand for financial assets increases their prices. There is a search for new investments as the original investors take profits from their initial positions while new investors, regretful at missing earlier opportunities, join the speculative surge. The pursuit of yield is met by the issuance of new, increasingly risky assets. The “speculative chase” further feeds a price bubble, which is always justified by claims of strong fundamentals.
At some point there is a reassessment of market conditions. This may be precipitated by a specific event, such as a leveling off of asset prices or a rise in the cost of funding. An initial wave of bankruptcies or defaults leads to the exit of some investors and price declines. Further selling and the revelation of the flimsy undergirding of the speculative bubble results in what Kindleberger calls “revulsion.” In a world of global financial flows there are “sudden stops” as foreign investors pull out their funds, putting pressure on fixed exchange rates. Contagion may carry the revulsion across national boundaries. The end, Kindleberger wrote, comes either when prices fall so low that investors are drawn back; or transactions are shut down; or when a lender of last resort convinces the market that sufficient liquidity will be provided.
The market for the bonds of developing economies has followed this script. The initial displacement was the improvement in the growth prospects of many emerging market countries at a time when the returns on fixed investments in the advanced economies were relatively low. A credible case could be made that emerging market economies had learned the lessons of the past and had structured their debt appropriately. But the subsequent increase in bond offerings by governments with below investment grade ratings shows that foreign investors in their eagerness to enter these markets were willing to overlook more risky circumstances. This leaves them and the governments that issued the bonds vulnerable to shocks in the global financial system. A rise in risk aversion or U.S. interest rates would lead to rapid reassessments of the safety and sustainability of much of this debt.
This potential crisis has caught the attention of those who would be responsible for dealing with its painful termination. The IMF’s Managing Director Christine Lagarde at the Fund’s recent annual fall meeting warned of the risk of “a tightening of the financial markets and the potential capital outflows from emerging market economies or from low‑income countries where there has been such a search for yield in the last few years.” The IMF has dealt with this type of calamity before, and it never ends well.