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    GSAM Insights

    NAVIGATING EXTERNAL EM DEBT

    January 6, 2023  |  8 Minute Read

    2022 in Review: Resilience Overshadowed by Idiosyncratic Distress

    A tough macro backdrop caused by the pandemic, Russia’s invasion of Ukraine and tighter global financial conditions has placed pressure on emerging market (EM) sovereign borrowers in 2022. Sri Lanka defaulted on its debt, Ukraine restructured its debt following the onset of war, and Pakistan’s external bonds recently entered distress.1 Around 13 sovereigns in the external EM debt index that hold a CCC- or lower rating (by at least one credit rating agency) have bond prices significantly below par,2 and this group is largely responsible for sharp weakness in the external EM bond market this year. Excluding sovereigns in distress, EM sovereign bond spreads are broadly unchanged year-to-date and have outperformed similar rated US corporate bond spreads.1 We believe this reflects economic resilience in the broader market, particularly among middle-income—and often larger—EM sovereigns.

     

     

    Pockets of Vulnerabilities

    A small cohort of lower-rated EM economies that have lost access to external bond markets face challenges meeting near-term external and fiscal needs, and in repaying upcoming debt maturities. Indeed, several EM sovereigns have already defaulted. To understand which countries are most vulnerable to funding challenges going forward we assessed external balances relative to currency reserves (Exhibit 1) and fiscal balances relative to interest costs (Exhibit 2).

     

     

    Exhibit 1: Locating External Financial Vulnerabilities

     

    EM country external financing vulnerabilities and simple average by rating cohort (in green).  We have labeled the countries where we perceive vulnerabilities to be greatest.

    Source: Goldman Sachs Asset Management, J.P.Morgan. As of Q3 2022.

    Under pressure from a hawkish Fed and stronger US dollar, many EM central banks have been drawing down on currency reserves. The decline in currency reserves is partly due to changes in the valuation of reserve holdings (in USD terms) as other currencies depreciated versus the dollar, causing a valuation loss on the share of reserves held by EM central banks in non-dollar currencies.

     

     

    Exhibit 2: Locating Fiscal Financial Vulnerabilities

     

    EM country fiscal financing vulnerabilities and simple average by rating cohort

     

    Source: Goldman Sachs Asset Management, J.P.Morgan. As of Q3 2022.

     

    Our analysis suggests Pakistan, Sri Lanka, Bolivia, Argentina, Angola, and Egypt are among the most vulnerable from the perspective of currency reserves relative to external financing needs. Meanwhile, Egypt, Ghana, Sri Lanka, Ukraine, and Zambia are among the most encumbered from a fiscal financing standpoint. Considering the vulnerabilities, certain countries may be unable to afford or access market funding over the coming year. The good news is that EM countries have alternative funding sources available to them: bilateral lenders and the International Monetary Fund (IMF). The bad news is that securing funding from both sources is proving challenging. We believe it is important for investors in EM sovereign debt—who are key providers of capital to EM economies—to appreciate that the mechanisms of financial support available to countries has evolved considerably in recent years. We explore the various sources of financial support and related considerations in more detail in Box 1.

     

    That said, weakness appears to be largely confined to smaller low-income countries that have a small weight in the external EM debt benchmark. For example, the average weight of B-rated issuers is 1% versus 3% for A-rated issuers (Exhibit 3). In our view, this lowers performance contagion risk from a single default, assuming defaults are confined to high yield (HY) issuers, and do not stem from unanticipated surprises among investment grade issuers.

     

     

    Exhibit 3: Lower Quality Issuers Have a Low Weight in the External EM Debt Index

     

    Source: Based on the J.P. Morgan Emerging Market Bond Index (EMBI). As of October 2022.

     

     

    Broader Resilience

    Beyond a select number of sovereigns in distress, external EM bond spreads have been relatively well behaved. This is because larger, middle-income countries have demonstrated resilience. The five largest countries in the external EMD index by GDP—namely, Brazil, China, India, Indonesia, and Mexico—do not appear at risk of an external crisis. Meanwhile, the two largest EM economies—China and India—have large stockpiles of foreign exchange reserves, while China closely controls capital flows and India is not overly reliant on foreign funding.

     

     

    Risks Are Largely Priced

    In our view, bond valuations in vulnerable economies—including two large sovereigns (Argentina and Turkey)—already largely reflect debt distress. Market pricing also reflects the prospect of additional defaults, including in Ghana and Pakistan. Importantly, the market appears to be distinguishing between countries in—or close to—distress and those that display relative resilience. For example, although spreads on the HY external EMD index are at wide levels seen in prior stress periods, spreads for BB-rated bonds (the highest HY rank) are below stressed levels (Exhibit 4).

     

     

    Exhibit 4: Higher Quality Bonds Have Proved Relatively Resilient With More Limited Spread Widening

     

    Source: J.P. Morgan Global Diversified Emerging Market Bond High Yield Index. As of November 14, 2022.

     

     

    Differentiation in market pricing is also evident when looking at the number of sovereigns whose bonds trade at distress levels (i.e., spreads at 900bps or more) compared to spreads for the HY portion of the market. Specifically, the number of countries in distress is in line with 2008 and 2020, however the corresponding HY spread level is lower. In other words, spread widening has largely been limited to distressed bonds rather than the broader HY market. This may reflect the fact that the past couple of years has involved a gradual deterioration in certain EM sovereign fundamentals and not a single event shock—like the onset of the pandemic in 2020—which can create indiscriminate weakness in the market.

     

     

    The New Year Brings New Challenges and Opportunities

    Funding challenges suggest negotiations on debt restructuring and IMF support are likely to be a feature of the outlook for several (mostly smaller, lower-rated) EM economies in 2023. A weaker growth environment coupled with ongoing Fed tightening and rising recession risks could see more sovereigns enter distress. However, we do not expect contagion to spread to resilient EM sovereigns or broader global financial markets. As our analysis shows, vulnerabilities are isolated, not broad-based, implying that blanket pessimism towards all EM external debt is unfounded. We also expect the market will continue to differentiate between distressed and non-distressed bonds to preserve funding for higher quality (and often larger) economies with deep trade and financial linkages globally.

     

    That said, we are mindful that external EM debt will face stiffer competition from higher yields in developed market (DM) economies following broad-based rate hikes in 2022. This marks a change from the pre-pandemic decade when low DM yields led investors to seek higher yields in EM assets. But as we move into a new era for financial markets—one in which easy policy is no longer around to lift all assets—we expect greater opportunities for alpha generation through active management. It may take time for value to be unlocked in distressed bonds given lengthy restructurings; however, we expect higher yields in resilient sovereigns—across both the investment grade and high yield segments of market—to offer opportunities to generate positive total returns. Overall, we see value in being selective, paying close attention where sovereign bond restructurings have potential to progress or where economic fundamentals are not reflected in market valuations.

     

     

    BOX 1: EM FUNDING CHALLENGES

    Bilateral Funding: China in Retreat

    China is the leading bilateral lender to EM countries (see Box 2), particularly to lower-income countries, but funding from China has slowed in recent years (Exhibit 5). We think this is for two reasons. First, China’s lending boom prior to 2015 did not yield the expected returns, perhaps because that lending occurred just before the price of oil and other key commodities exported by African debtor countries started to decline.3 Second, economic growth in China has stepped down from the double-digit levels seen prior to the global financial crisis.

     

     

    Exhibit 5: Chinese Development Lending has Slowed Since 2015

     

    Source: Usman, Zainab. 2021. What Do We Know About Chinese Lending in Africa? Data for China reflect loans at both concessional and commercial rates but exclude grants and other forms of foreign aid, which are comparatively small in volume. The figures for the US, Germany, UK, and France include both concessional loans and grants as well as other forms of aid flows.

     

     

    IMF Funding: A Challenging Process

    Multilateral institutions such as the IMF were established to support countries in managing debt risks and resolving debt distress. But support hinges on debt being on a sustainable trajectory; a condition that faces two key challenges today. First, the starting point for debt levels is higher. Second, progress on debt restructuring is limited by a lack of coordination between China and other creditors. Coordination challenges stem from US-China tensions and differences in approach to debt rescheduling both between China and other creditors and among various Chinese creditors (which includes state owned banks, development banks and export agencies). Broadly speaking, Chinese creditors appear to favor debt rescheduling (i.e., an extension of the repayment period), while other creditors, including Paris Club countries, have evolved their approach to debt distress by allowing for some debt forgiveness (i.e., “haircuts”).

     

     

    The Paris Club is an informal group of 22, mostly high- and middle-income countries such as the US, UK and Japan that seek to find coordinated and sustainable solutions to the payment difficulties experienced by debtor countries. It was formed by creditor countries in 1956 to address debts owed by sovereigns, at a time when its membership dominated the global market for bilateral lending.

     

     

    The Common Framework: So Far, Uncommon

    G20 countries established a “common framework” for debt relief in 2021, which China joined.4 However, debt restructuring under this framework has been disappointingly uncommon. For example, two years have passed since Zambia missed a debt payment, yet negotiations with the official sector are ongoing. For countries that do not qualify for the Common Framework, the restructuring process has been similarly slow.

     

    The longer the restructuring, the greater the economic cost to both creditors and debtors. An impasse with Chinese creditors contributed to a lack of progress on a debt restructuring in Sri Lanka in 2022. Sri Lanka subsequently defaulted. One potential resolution for the current coordination challenges would be for G20 economies and the IMF to recreate something like collective action clauses (CACs) used in the private sector, as these allow a given majority of bondholders to support a restructuring and unite all remaining holders, thus improving the orderliness and predictability of a restructuring process.

    BOX 2: CHINA'S FOOTPRINT IN GLOBAL FINANCE

    China has Become a Dominant Lender for Developing Countries

    China’s role in global finance has expanded alongside its mark on world trade and global GDP. But the contours of China’s footprint in global finance are opaque; it does not report its official lending to other economies and there is no comprehensive standardized data on Chinese overseas debt stocks and flows.5 With this data caveat in mind, available studies indicate that in dollar terms, Chinese overseas lending in 2017 was greatest to Russia, Pakistan, and Angola (Exhibit 6). Debt owed to China relative to a debtor country’s GDP is larger—and in some cases the largest—in smaller economies such as Djibouti, Tonga, and Maldives.

     

     

    Exhibit 6: Large-Scale Chinese Lending

     

    Source: China’s Overseas Lending Sebastian Horn, Carmen M. Reinhart, and Christoph Trebesch NBER Working Paper, revised May 2020. Data as of 2017.

     

     

    China is a Key Creditor for Many African Countries

    In the first two decades of this century, African countries such as Angola, Ethiopia, and Zambia were among the largest recipients of loans from China (Exhibit 7), with financing often associated with China’s “Belt and Road” initiative. Angola alone received over $43bn in loans. Overall, whether in dollar terms or relative to a borrower’s GDP, China has emerged as a significant funding source for EM economies over the past couple of decades.

     

     

    Exhibit 7: China Is a Key Creditor for African Countries

     

    Source: China-Africa Research Initiative (CARI) at Johns Hopkins University.

     

     

    China’s Approach to Debt Restructuring Differs From Other Major Creditors

    Restructuring of Chinese loans are now a major share of sovereign credit events. For example, between 2008 and 2021, 71 debt restructurings involved Chinese loans compared to 21 on external bonds or loans involving private creditors (bondholders and banks).6

     

    China’s approach to debt distress since 2000 resembles that of private creditors and Paris Club lenders in the 1980s and 1990s: it favors debt rescheduling (i.e., an extension of the repayment period by increasing the maturity and/or grace period) rather than some nominal debt reduction (i.e., “haircuts”) as shown in Exhibit 8.

     

    The Paris Club and private creditors have shifted towards greater debt relief since the 1990s, especially after the Heavily Indebted Poor Countries (HIPC) debt relief initiative was all but completed in the late 2000s. Lessons of prior crises demonstrated that repeatedly rescheduling loans, rather than writing them down, can prolong economic distress in developing countries. The hope is that China learns from the lessons of prior creditors and crises, evolving its stance on debt restructuring which will allow for better coordination with other creditors.

     

     

    Exhibit 8: China Tends to Favor Debt Rescheduling Versus Debt Relief

     

    Source: Horn, Sebastian; Reinhart, Carmen M.; Trebesch, Christoph. 2022. Hidden Defaults. Policy Research Working Paper;No. 9925. World Bank, Washington, DC. © World Bank. https://openknowledge.worldbank.org/handle/10986/36965 License: CC BY 3.0 IGO.

     

     

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    1 Debt distress is typically defined as bonds trading at less than 50 cents on the dollar and/or bond spreads in excess of 900 basis points.

    2 Source: Goldman Sachs Global Investment Research, J.P.Morgan, Bloomberg. As of December 5, 2022.

    3 Source: Goldman Sachs Asset Management, Acker, Kevin, Deborah Brautigam, and Yufan Huang. 2020. Debt Relief with Chinese Characteristics. Working Paper No. 2020/39. China Africa Research Initiative, School of Advanced International Studies, Johns Hopkins University, Washington, DC. Retrieved from http://www.sais-cari.org/publications.

    4 In 2020, G20 economies agreed to a Debt Service Suspension Initiative (DSSI) that paused debt-service payments to bilateral creditors to allow developing countries to concentrate their financial resources on fighting the pandemic. The DSSI ran from May 2020 to the end of 2021; 48 out of 73 eligible countries participated and $12.9 billion in debt-service payments is estimated to have been suspended. Participating countries must make up the deferred amounts in full over the following four to six years. Once the DSSI ended, the Paris Club and G20 economies—including bilateral creditors such as China, India, Turkey, and Saudi Arabia—endorsed a “Common Framework” to coordinate and cooperate on debt treatments for up to 73 low-income countries. The framework is initiated at the request of a debtor country and is designed to ensure fair burden sharing.

    5 Source: China’s Overseas Lending Sebastian Horn, Carmen M. Reinhart, and Christoph Trebesch NBER Working Paper, revised May 2020. Data as of 2017.

    6 Source: Horn, Sebastian; Reinhart, Carmen M.; Trebesch, Christoph. 2022. Hidden Defaults. Policy Research Working Paper;No. 9925. World Bank, Washington, DC. © World Bank. https://openknowledge.worldbank.org/handle/10986/36965 License: CC BY 3.0 IGO.

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    FOR INFORMATION ONLY – NOT FOR WIDER DISTRIBUTION

    These materials are presented to you by Goldman Sachs Saudi Arabia Company ("GSSA"). GSSA is authorised and regulated by the Capital Market Authority (“CMA”) in the Kingdom of Saudi Arabia. GSSA is subject to relevant CMA rules and guidance, details of which can be found on the CMA’s website at www.cma.org.sa.

    The CMA does not make any representation as to the accuracy or completeness of these materials, and expressly disclaims any liability whatsoever for any loss arising from, or incurred in reliance upon, any part of these materials. If you do not understand the contents of these materials, you should consult an authorised financial adviser.

    UAE: FOR INFORMATION ONLY – NOT FOR WIDER DISTRIBUTION

    This document has not been approved by, or filed with the Central Bank of the United Arab Emirates or the Securities and Commodities Authority. If you do not understand the contents of this document, you should consult with a financial advisor.

    Israel: FOR INFORMATION ONLY – NOT FOR WIDER DISTRIBUTION

    This document has not been, and will not be, registered with or reviewed or approved by the Israel Securities Authority (ISA”). It is not for general circulation in Israel and may not be reproduced or used for any other purpose. Goldman Sachs Asset Management International is not licensed to provide investment advisory or management services in Israel.

    Index Benchmarks

    Indices are unmanaged. The figures for the index reflect the reinvestment of all income or dividends, as applicable, but do not reflect the deduction of any fees or expenses which would reduce returns. Investors cannot invest directly in indices.

    The indices referenced herein have been selected because they are well known, easily recognized by investors, and reflect those indices that the Investment Manager believes, in part based on industry practice, provide a suitable benchmark against which to evaluate the investment or broader market described herein. The exclusion of “failed” or closed hedge funds may mean that each index overstates the performance of hedge funds generally.

    Past performance does not guarantee future results, which may vary. The value of investments and the income derived from investments will fluctuate and can go down as well as up. A loss of principal may occur.

    Date of first use: January 5, 2023. 301610-OTU-1718061.

    © 2025 Goldman Sachs. All rights reserved.

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