Back to the eighties?

To my Millennial and Gen Z readers: You may not know this, but before you were born, developed countries didn’t have a financial crisis every decade or so. In fact, when it came to financial crises, that was considered to be a specialty of emerging markets. In particular, throughout the 1980s and 1990s, we quite regularly had to deal with sovereign default in some developing countries. The 1980s was a lost decade for Latin America with one country after another becoming over-indebted and many of them defaulting on their debt once oil prices declined and with it the hard currency revenues these countries needed to service their debt.

Practically every country in Latin America was affected, but to list the biggest events in chronological order:

• 1982: Argentina, Ecuador, Mexico, Venezuela

• 1983: Brazil, Chile

• 1986: Brazil

• 1988: Argentina

• 1990: Brazil, Venezuela

Barring some episodes in the 1990s like the Tequila Crisis in Mexico in 1994, the focus shifted eastward during the 1990s with the Asian crisis of 1997 and the Russian default of 1998. Not to be outdone by these upstart defaulters, Argentina decided to stage the world’s largest default seen up to that point in 2001 but since then it has been remarkably calm on the emerging market debt crisis front.

Of course, now we have President Erdogan of Turkey who is hellbent on forcing the Turkish central bank on keeping interest rates low in the face of some 30% inflation. The older ones amongst us all know how that will end. The Turkish Lira will devalue to the point where Turkey will no longer be able to service its Euro- and Dollar-denominated debt and then has to default. The IMF will come in and reform the financial system while the country will drop into a serious recession. And the IMF will get the blame for the pain and suffering the people of Turkey will face.

But I fear that we won’t even need mismanagement like in Turkey to see another wave of emerging market defaults in this decade. The charts below are taken from a study by World Bank economists and show how much government debt and in particular private sector debt has increased in emerging and developing economies (EMDE) vs. advanced economies.

Debt boom in emerging markets

Source: Kose et al. (2021)

As a young reader, you may say that it isn’t so bad for emerging markets since advanced economies have much higher debt levels. But advanced economies have their own currencies and issue bonds in their home currency. Emerging markets, meanwhile have 49% of their debt denominated in foreign currencies (i.e. Dollar or Euro), virtually unchanged since 2010. Also, 42% of the debt is held by foreigners (up from 38% in 2010) most of which sit in developed countries and don’t really hold on to that debt if they start to see trouble on the horizon.

That means that if there is trouble in these emerging markets, foreigners will be keen to sell their bonds, pushing prices down. Meanwhile, the local currencies of these emerging markets will devalue rapidly, making it harder to pay interest on foreign currency bonds. And finally, if oil revenues decline as oil prices drop, these countries will have a hard time generating the Dollars needed to pay for the debt.

As the US is starting to hike interest rates and energy shortages resolve in 2022, the first steps are being taken that could lead to a problem for some emerging markets. I don’t expect a major blow-up right away but the air is getting thinner. Consider these statistics from the report: Two-thirds of emerging markets currently experience a government debt boom. These debt booms have been going on for longer than the average debt boom in the past and the economic growth these countries experienced during the debt boom was weaker than in past episodes. The result is that the fiscal deficits are now bigger than in previous episodes and the debt sustainability is worse than ever before. In the past, when these conditions were met, half of the debt booms ended in a sovereign default.

It could well be that debt crises will once again be a feature of emerging markets during the 2020s.