The temptation for emerging and developing countries to borrow in dollars in the coming years will be accentuated by their limited ability to keep on borrowing internationally in their own currencies. In many economies, including systemically important ones such as Brazil and South Africa, the willingness of international portfolio managers to own local-currency-denominated debt has been heavily constrained in recent years. This has resulted in a sharp fall in the share of local-currency-denominated public debt owned by foreign investors. In Brazil, for example, the share of domestic public debt owned by foreigners has fallen from over 20 per cent in 2015 to less than 10 per cent in 2020.
This relative aversion on the part of international portfolio managers towards the local-currency debt markets of a number of emerging economies remained an important theme in 2020, thanks to the pandemic-related rise in public debt/GDP ratios in countries such as Brazil and South Africa. Funds that invest in emerging-market local-currency bonds saw large outflows, resulting in strong upward pressure on bond yields in the worst-affected countries. Although some central banks in emerging markets introduced asset-purchase initiatives to help contain the rise in bond yields, these central banks generally lack the capacity of their developed-country counterparts to buy bonds and suppress yields. For most emerging economies, this kind of activity would create a risk of capital outflows, since central bank bond purchases would normally raise fears of inflation or financial instability.
The economic effects of the pandemic have led to huge increases in the stock of public sector debt in emerging economies – which has risen, as a share of GDP, by around 9 percentage points on average – threatening a vicious circle of self-reinforcing debt and growth dynamics. First, the pandemic-induced global recession is causing debt/GDP ratios to rise, and countries’ risk profiles thus to deteriorate. That deterioration is leading foreign investors to buy fewer local-currency bonds, which pushes up the yields on those bonds. For countries such as Brazil, South Africa and Mexico, real bond yields are currently very high relative to real GDP growth rates. High domestic yields make it more difficult for economies to recover. In turn, subsequently weak growth rates entrench market participants’ concerns about public finances, pushing yields even higher.
To date, domestic insolvency in emerging economies has not featured much in regulators’ analyses of financial stability risks. The incidence of default on domestic-currency debt in emerging markets is low: the Bank of Canada-Bank of England Sovereign Default Database records only 31 countries as having defaulted on domestic debt obligations between 1960 and 2017. Because a government can ultimately print the currency in which its local debt obligations are denominated, inflation is usually considered to be a more convenient path to follow than default.
For countries such as Brazil, South Africa and Mexico, real bond yields are currently very high relative to real GDP growth rates.
This may not always remain true, however: inflating one’s way out of unpayable debt will tend to impose the greatest cost on the poor, who are least able to protect themselves against the ravages of inflation. So it is as well to begin today to try to limit the build-up of domestic insolvency risks in a world characterized by weak growth, high public debt, and limited foreign investor appetite for emerging-market local-currency bonds.
The most reliable way to do this would be for policymakers and regulators to return to the subject of GDP-linked bonds. Debate about these kinds of instruments has been building for a number of years, but the potential appeal of GDP-linked bonds has been greatly enhanced by the context of rising debt/GDP ratios in emerging economies.
It is important to bear in mind that the inclusion of GDP-linked bonds as part of a government’s normal funding cycle is quite different from the use of GDP-linked recovery warrants, which have been issued in connection with debt restructurings in countries such as Argentina and Greece. In those cases, investors are promised a pay-off if the level of GDP reaches agreed thresholds; such warrants should therefore be thought of as an asymmetric reward for creditors in exchange for their agreement to provide debt relief. In contrast, if GDP-linked bonds were to become part of a country’s normal funding cycle, the transaction would be more symmetrical: high-growth periods would deliver gains to creditors when borrowers could most afford it, while low-growth periods would allow borrowers to enjoy debt service costs lower than might otherwise be the case.
The proposition is straightforward. A fund manager might be reluctant to buy a government’s securities if the yield on those securities is too high, since a high yield might be understood to signify an unacceptable default or inflation risk. But by issuing securities today with the promise of growth-related increases in coupon payments, a government can ensure that both debtor and creditor benefit. The creditor has the expectation of rising coupon payments in the future, while the issuing government benefits from lower debt service obligations in the short term, which helps to break the cycle described above. By making room for more rapid growth, the introduction of GDP-linked bonds might catalyse an increase in foreign demand for domestic debt securities issued by emerging-market governments.
To establish GDP-linked bonds as a normal part of market practice for emerging economies will almost certainly require one of two steps: that governments in developed countries first establish the viability of such instruments by issuing GDP-linked bonds themselves; or that advanced economies, at the very least, provide high-level sponsorship of the idea. A precedent here can be found in the use of collective-action clauses in emerging-market Eurobond contracts in the early 2000s. It was the enthusiastic endorsement of collective action clauses by the US government’s then undersecretary of the Treasury for international affairs, John Taylor, that made it possible for Mexico to issue a bond with a collective-action clause in 2003. Within months, collective-action clauses became standard for emerging-market issuers.
