Last month, we recently counted 27 countries with US$ bonds yielding more than 10% or that are in default (28 today with the addition of Turkey), a decade high and more than double the number in December 2021 (13) and three times the number in December 2019 (8). While much of the yield increase has been driven by higher US yields, there are now 14 countries in the Bloomberg EM Sovereign Index with spreads over 1000bps, which is a fifth of the index (by number of countries, not market cap). This suggests that a substantial chunk of the EM universe is now locked out of the market, which has already been reflected in subdued EM issuance over the first 5 months of the year and will likely continue into the second half of the year.
While we think the recent EM credit sell-off may have unlocked some pockets of value in higher-yielding frontier markets, EM spreads will likely stay under pressure as we enter the second half of the year amid the ongoing policy tightening by DM and risks of further inflation and rate surprises (see here, here and here). The more prolonged the tightening of global financial conditions, the more difficult it will be for countries with large current account deficits or external amortizations to meet their external financing needs. This will especially be the case for countries with limited reserve buffers that are locked out of the market, who will need to find alternative sources of external financing to plug the gap.
We have previously explored external vulnerability in detail with our external liquidity and taper tantrum scorecards, but here we present two simple charts that, in our view, best summarise which countries are at risk from a prolonged stop in external financing. Using IMF and World Bank projections for comparability, the charts map each country’s average gross external financing requirement (GEFR) from 2022-23 as a % of GDP and a % of official reserve assets, respectively, against their Bloomberg EM Sovereign Index spread. Countries are flagged as vulnerable if their GEFR exceeds 5% of GDP or 50% of reserves (with the former consistent with the IMF’s early warning threshold) and have an index spread of >1000bps (which we take as an indication that they are “locked out” of the market).
Excluding countries that have already defaulted, the first chart flags Tunisia, El Salvador, Ethiopia, Kenya, Pakistan and Ghana as the most vulnerable countries (with Egypt just on the threshold), and the second flags Ethiopia, Tunisia, Pakistan and Kenya (with Ghana and Egypt both on the threshold). There are no surprises here, with broad agreement among market participants that these countries are at risk (reflected by significant underperformance relative to the index).
On the other end of the spectrum, Senegal and Georgia both stick out as countries with large GEFR but relatively contained spreads, which may indicate vulnerability to further spread widening if global financial conditions remain tight (we exclude Mozambique as its large current account deficit is driven by LNG megaprojects), while Angola, Ecuador and Nigeria stand out as countries with wide spreads but low or negative GEFR, which could indicate greater resilience to a prolonged period of tight global financial conditions than markets are currently pricing (we exclude Argentina as a special situation).
If global financial conditions continue to tighten and/or market access is not expeditiously restored, vulnerable countries will be reliant on a sustained uptick of bilateral and multilateral external financing flows to avoid debt distress, or will be forced to tighten policies, resort to potentially inflationary domestic financing, or to consider capital controls. Significant exchange rate depreciation may also be required to reduce external imbalances for countries like Kenya and Egypt that have kept a tight lid on currency depreciation.