Poor countries feel sting of local-currency debt

Debt issued by emerging-market governments and companies in their local currency reached $12.5 trillion in 2021, according to data from Bank of America that excludes China’s enormous borrowings in the yuan. That compares with $4 trillion in foreign-currency debt.

The fate of local-currency debt has become a key stumbling block in debt-restructuring negotiations in Ghana, Sri Lanka and Zambia. And it is forcing investors, policy makers and economists to rethink what an emerging-market debt crisis looks like.

“The crises of the mid- and late 1990s that were mostly driven by foreign-currency debt were very traumatic for many of us, so then we started thinking of that risk," said Ugo Panizza, a professor who studies sovereign debt at the Geneva Graduate Institute. Local-currency borrowing was meant to be easier to manage. “Now we’re facing a different type of debt crisis," Mr. Panizza said.

Rising interest rates, combined with soaring food and fuel prices triggered by Russia’s invasion of Ukraine, have hit the world’s poorest nations hard this year. Many engorged on debt over the previous decade and are now in talks for relief from their lenders and rescue packages from the International Monetary Fund.

The tug of war between foreign and local creditors is playing out in the West African nation of Ghana, which in November said it would restructure some of its $49 billion in public debt. The country’s finance minister said last month that payments for the local-currency portion of that debt pile made up 78% of its interest bill this year through September.

Foreign bondholders could see the value of their bonds cut by one-third or more under some proposals that have been floated by finance-ministry officials, according to Stuart Culverhouse, chief economist at emerging-market research firm Tellimer.

It is too early to say how the restructuring will affect domestic bondholders. The country’s finance ministry didn’t respond to a request for comment. It said in November that details of the restructuring were still being discussed.

However, holders of the foreign bonds are pushing for a comparable restructuring among the local-currency debt since it makes up the bulk of Ghana’s current payments.

Domestic debt is legally easier to restructure than foreign-currency bonds that are typically governed by U.K. or U.S. law, said Mitu Gulati, a professor at the University of Virginia School of Law. But often domestic banks and pensions own large chunks of government debt and would suffer if the value of those investments were sharply written down.

Sri Lanka and Zambia have pledged not to restructure local-currency debt, but investors and ratings companies are skeptical that they will be able to keep those promises.

Fitch Ratings sees a high chance that Sri Lanka will end up including local-currency debt in its restructuring. Moody’s says risks remain high that Zambia will have to do the same for some domestic debt, with particular focus on the $3.2 billion held by foreigners.

Rising borrowing costs means Sri Lanka expects interest payments on domestic debt to essentially double between 2021 and 2023. Zambia forecasts its domestic debt bill will rise by 66% in that period.

“There’s a balance between going fast and being holistic, and as an investor in a country, I lean toward being holistic," said Samy Muaddi, an emerging-market bond portfolio manager at T. Rowe Price. “Most of the debt, most interest burden is now domestic."

The finance ministries of Zambia and Sri Lanka didn’t respond to requests for comment.

Previous emerging-market debt crises, like the Latin American debt one in the 1980s and the Asian financial crisis of the late 1990s, were rooted in U.S. dollar borrowings. A rising dollar makes those debts become more expensive for countries to repay, a vulnerability often referred to as emerging markets’ “original sin."

With local-currency borrowing, the value of those debts wouldn’t increase if a country’s currency depreciated.

The IMF and World Bank provided training to emerging-market officials on how to build out local debt markets and open them up to foreign investors. The Group of 20 nations joined the cause in 2011, launching an action plan to support local-currency bond markets in developing nations.

Emerging-market governments issued trillions of dollars worth of local-currency debt in the decade that followed.

China and larger emerging markets such as Brazil and India led the charge, but smaller developing countries also joined in. In some of the world’s poorest countries, local-currency debt more than tripled to 28% of gross domestic product by 2021 from 8% in 2010, according to IMF data.

While local debt has helped insulate many emerging markets from global shocks, some smaller countries were unprepared when the foreign investors who flocked to their local-currency markets suddenly wanted out, said Francesc Balcells, head of emerging-market debt at FIM Partners.

Foreign investors pulled a net $20 billion from emerging-market local bond funds this year through November, according to a JPMorgan Chase analysis that excludes China. The investor exodus added to pressure on emerging-market currencies and inflated the value of their U.S. dollar debts.

Countries turned to borrowing more in local markets to plug budget gaps, but at sky-high rates that are driving up domestic debt costs. Ghana sold a six-month Treasury bill in November with an interest rate of 36%, up from the rate of 13% it borrowed at in January.

“Domestic debts can be as destabilizing as external ones," said Theo Acheampong, a Ghanaian economist and senior analyst at S&P Global Market Intelligence. Foreign investors are “quick to sell out as soon as they sense any sign of distress."

Another option for governments is to let inflation reduce the value of their domestic debts, said Kenneth Rogoff, former chief economist at the IMF and currently a Harvard University professor.

“You just print money. l’m not saying everybody should do this. But if you’re in desperate straits, you do it," he said.