Some of the world’s poorest economies borrowed in their own currency to protect themselves from painful swings in the US dollar. Now this strategy might come back to bite.
According to Bank of America data, which excludes China’s massive yuan-denominated borrowing, the debt issued by emerging market governments and corporations in their local currency totaled $12.5 trillion in 2021. This is offset by $4 trillion in foreign currency debt.
The fate of local currency debt has become a key stumbling block in debt restructuring negotiations in Ghana, Sri Lanka and Zambia. And it’s forcing investors, policymakers and economists to reconsider what an emerging market debt crisis looks like.
“The crises of the mid and late 1990s, mainly caused by foreign currency debt, were very traumatic for many of us, so we started thinking about this risk,” said Ugo Panizza, a professor who conducts research on public debt at the Geneva University Institute. Borrowing in local currency should be easier to manage. “Now we face a different kind of debt crisis,” Mr. Panizza said.
Soaring interest rates coupled with soaring food and fuel prices triggered by Russia’s invasion of Ukraine have hit the world’s poorest nations hard this year. Many have borrowed over the past decade and are now in talks for relief from their lenders and bailouts from the International Monetary Fund.
The tug-of-war between foreign and local creditors is playing out in the West African nation of Ghana, which announced in November it would restructure some of its $49 billion sovereign debt. The country’s finance minister said last month that payments on the local currency portion of that debt accounted for 78% of his interest bill this year through September.
Soaring interest rates coupled with soaring food and fuel prices have hit poor countries hard this year.
Photo: Nipah Dennis/Agence France-Presse/Getty Images
According to Stuart Culverhouse, chief economist at emerging markets research firm Tellimer, foreign bondholders could see the value of their bonds cut by a third or more if some proposals were put forward by Treasury officials.
It is too early to say how the restructuring will affect domestic bondholders. The country’s Treasury Department did not respond to a request for comment. Details of the restructuring were still being discussed, it said in November.
However, foreign bondholders are pushing for a similar restructuring of local currency debt, which accounts for the bulk of Ghana’s current payments.
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Domestic debt is legally easier to restructure than foreign currency debt, which is usually governed by UK or US law, said Mitu Gulati, a professor at the University of Virginia School of Law. But often domestic banks and pensions hold large government debts and would suffer if the value of those assets were severely written down.
Sri Lanka and Zambia have pledged not to restructure their local-currency debt, but investors and rating agencies are skeptical about delivering on those promises.
Fitch Ratings sees a high chance that Sri Lanka will eventually include local currency debt in its restructuring. According to Moody’s, risks remain high that Zambia will have to do the same for some domestic debt, with a particular focus on the $3.2 billion held by foreigners.
Rising borrowing costs mean Sri Lanka expects interest payments on domestic debt to essentially double between 2021 and 2023. Zambia forecasts that its domestic debt bill will increase by 66% over this period.
“There’s a balance between speed and holism, and as an investor in a country I tend to go for holism,” said Samy Muaddi, portfolio manager for emerging market debt at T. Rowe Price. “Most of the debt, most of the interest burden is now domestic.”
The finance ministries of Zambia and Sri Lanka did not respond to requests for comment.
Previous emerging market debt crises, such as the Latin American debt crisis of the 1980s and the Asian financial crisis of the late 1990s, had their roots in US dollar borrowing. A rising dollar makes it more expensive for countries to repay this debt, a vulnerability often cited as the “original sin” of emerging markets.
When borrowing in local currency, the value of that debt would not increase if a country’s currency depreciated.
The IMF and World Bank offered training to emerging market officials on how to build local debt markets and open them to foreign investors. The Group of 20 nations joined the cause in 2011 and launched an action plan to support local currency bond markets in developing countries.
Emerging market governments issued trillions of dollars worth of local currency bonds over the next decade.
China and larger emerging economies like Brazil and India led the rush, but smaller developing countries also joined. In some of the world’s poorest countries, debt in local currency terms has more than tripled from 8% to 28% of gross domestic product by 2021 in 2010, according to the IMF.
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While local bonds have helped protect many emerging markets from global shocks, some smaller countries were caught off guard when foreign investors who flocked to their local currency markets suddenly wanted to exit, said Francesc Balcells, head of emerging market debt at FIM Partners.
Foreign investors withdrew a net $20 billion from emerging-market local bond funds this year through November, according to an analysis by JPMorgan Chase that excludes China. The exodus of investors increased pressure on emerging market currencies and increased the value of their US dollar debt.
Countries have turned to borrowing more from local markets to fill budget gaps, but at sky-high interest rates that are driving up domestic debt costs. Ghana sold a six-month Treasury bill at a rate of 36% in November, versus the 13% rate it borrowed at in January.
“Domestic debt can be just as destabilizing as external debt,” said Theo Acheampong, a Ghanaian economist and senior analyst at S&P Global Market Intelligence. Foreign investors “sell quickly as soon as they sense signs of distress.”
Another option for governments is to let inflation reduce the value of their domestic debt, said Kenneth Rogoff, a former IMF chief economist and current professor at Harvard University.
“One only prints money. I’m not saying everyone should do this. But if you’re in a desperate situation, do it,” he said.
Write to Chelsey Dulaney at [email protected]
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