EM sovereign strains inch upward in 2024, but remain historically low

Soon I will be publishing twice-yearly detailed results for estimates of the probability of sovereign debt stress for up to 112 market-access countries, which will be available to this newsletter’s subscribers and on premium research platforms in an in-depth note.

High-level overview of sovereign stress in EMDEs

To measure sovereign stress, I plug in data to an IMF model (see “Variables” below for more details) that is designed to predict the likelihood of sovereign stress 1-2 years ahead.

Estimates for 44 emerging and developing economies at middle income levels suggest that average sovereign debt strains remain relatively well-contained in 2024.

Although the average probability of stress has inched up slightly from 2023, average stress probabilities for EMDEs remain at their lowest level in two decades (ex-2023), according to this IMF model.

While these absolute probabilities should be treated with caution, changes over time provide useful insights into the pressures on creditworthiness that EM sovereign issuers face.

Since 2002, the lowest average readings on these probabilities of sovereign stress have been recorded in 2023, 2004, and 2024.

Asset class maturity

The fact that average EM sovereign strain probabilities have remained below 25% for the past two years is a symptom of asset class maturity.

EM resilience is all the more remarkable given the post-pandemic inflationary shock from 2021-2022 and the higher interest rates that central banks responded with.

Indeed, the fact that many EM central banks began tightening policy before the Fed, which responded relatively late to surging prices, help insulate them from the rise in U.S. rates.

Upper- versus lower-middle income

In a further positive sign for EM, there are only three upper-middle income countries above the 50% likelihood threshold of sovereign stress in 2024, and there were only two in 2023.

There are only a handful of prior years where this number was at 3 or below: 2003, 2004, 2006, 2010, 2012, 2013, and, of course, 2023.

As for lower-middle income countries, only 3-4 countries have been above 50% in any given year since 2019.

In the 2015, 2016, and 2018, the number of countries above that threshold had jumped to 6, 7, and 9, respectively.

This was perhaps a sign of the larger number of frontier markets having entered the Eurobond market in the 2010s, even as EM faced pressures related to heavier debt burdens, China’s economic problems in 2015, and the Fed’s rate hikes in 2018.

Caveat

This is purely a baseline analysis of macro and debt-related indicators and does NOT include crucial qualitative factors such as policy direction, commitment to reform, and credibility.

Rather, the usefulness of this model is as a baseline from which to compare sovereign borrowers before proceeding with further analysis that accounts for idiosyncratic and qualitative information.

It is also a useful model to see the direction of travel over time of countries in terms of sovereign debt strains.

Variables

The IMF released this logit model as part of the review of its Debt Sustainability Framework for Market Access Countries, published in 2021.

The dependent variable in this model is sovereign stress as defined by the IMF's MAC DSF, which isn't limited to default: certain spread and yield dynamics count as well.

Independent variables are related to institutional quality, stress history, the current account, the real effective exchange rate, the credit gap, government debt, external public debt, reserves, and VIX.