This guest post is from Gabriel Sterne, the Head of Global Macro Research at Oxford Economics.
Long-term valuations of EM sovereign dollar debt look increasingly favourable as governments issue an ever-greater share of debt in their own currency. In the event of a crisis, many would find that the remaining share of FX debt is too small to make it worth the trouble of imposing haircuts as part of efforts to restore debt sustainability.
The background story is one of a general improvement in EM resilience to external shocks. Between 2011 and 2016, EM endured unprecedented capital outflows and a slump in commodities. But EMs managed to pass the “mother of all stress tests” then with a much lower incidence of recessions and defaults than in previous episodes.
Of the various reasons for EMs’ improved resilience, one in particular favours the dollar-debt asset class relative to those with currency exposure.
EMs have been able to issue a far greater share of debt in local currency (known in the trade as reducing original sin). Between 2004 and 2012, the average share of local currency issues in total external sovereign debt in 14 large EMs increased dramatically, rising to 60 per cent from 15 per cent:
This trend has profound implications for how losses will be distributed among different types of EM debt under sovereign stress. In previous decades, when dollar-denominated debt was the main form of borrowing, the most effective way to reduce government debt burdens was by imposing haircuts.
Nowadays, the (generally) small share of dollar debt means that distressed sovereigns have a greater incentive to depreciate and inflate away the value of local currency issues. That avoids the legal and reputational costs of a default on dollar debt without inflating the real burden of those foreign obligations too much.
Ukraine offers the best recent case study. The country’s debt was widely seen as unsustainable by 2014. Yet the IMF programme involved a very limited haircut given the stress, with more pain being endured by holders of local currency assets and via an ambitious fiscal adjustment.
Over the entire period of Ukraine’s distress (January 2012 to date), holders of dollar bonds fared much better than those exposed to local currency assets. Even after taking the restructuring into account, total returns on FX debt were over 15 per cent, whereas a 1-year deposit on local money markets made -30 per cent when converted back to dollars.
I regard Greece as the exception that proves the rule (or at least the trend) of more favourable outcomes for FX bondholders. The recent rally in Greek sovereigns and residual risks have little to do with the arguments made here. The severe haircut of more than 70% (in NPV terms) was possible partly because the entire debt stock was akin to FX debt, insofar as Greece could not choose macro policies that inflated away its value in euros. For similar reasons, Venezuela isn’t relevant here either, as its debt stock is almost entirely in dollars.
Sovereign ratings will inevitably be slow to encompass the “small is beautiful” trend. They rely partly on historical default probabilities. This means it could take decades for ratings to catch up with any improved reality. It’s no surprise, then, that in recent years markets have judged sovereign risk more favourably than ratings.
Furthermore, ratings do not explicitly factor in recovery values under default, whereas market prices should. Losses under default are likely to be smaller than in previous decades. The IMF’s crisis resolution policies have focused increasingly on reprofiling debt service, rather than haircuts. The goal is to provide respite on debt service while other adjustment policies are given time to work, including depreciation and negative real rates.
Markets may also be too slow to fully grasp the implications of an improved reality. We estimate that factoring in the lower average default rates and the higher recovery values of the last decade or so boosts expected returns by around 50bps. The gains would be bigger still if there is a structural decline in risk premia.
Our analysis – which does not aim to be a comprehensive vulnerability metric – gives an indication of which sovereigns to favour despite other vulnerabilities. These include Brazil, South Africa, Turkey, Ghana, Ivory Coast and Zambia.
It is hard to envisage circumstances leading Brazil to default, as dollar bonds account for only 2 per cent of GDP. In such circumstances, spreads of around 300bps over US Treasuries appear too generous. Did someone say buy the dip?