Frontier markets and Mena oil-importers most exposed to funding shock, Moody's says

A sharp increase in borrowing costs could raise the debt burden for Egypt, Pakistan, Ghana, Jordan and Sri Lanka

A grain seller at a market in Colombo. Sri Lanka is facing its worst financial crisis in more than 70 years. EPA

Low-rated frontier markets and oil-importing countries in the Middle East and North Africa (Mena) region are most exposed to an extended funding shock amid the tightening of global financial conditions and monetary policy owing to Russia’s war in Ukraine, Moody’s Investors Service said.

Borrowing costs are expected to rise steeply while currency depreciation could increase debt burdens for countries with significant foreign currency exposure, the rating agency said in a report.

Capital outflows amid the tightening of global financial conditions would weaken their external stability.

“A spike in borrowing costs would weaken debt affordability for Egypt, Pakistan, Ghana and Jordan, all of whom already have a high-interest bill or large borrowing requirements. Sri Lanka's debt affordability, already the weakest by far, would weaken even further,” Moody’s said.

“Currency depreciation would increase the debt burdens for those with significant foreign-currency exposure. Among sovereigns without stable pegs, Suriname, Laos, Argentina would see among the largest increases in debt in our stress scenario of a 20 per cent depreciation shock.”

Moody's also said capital outflows would weaken external stability in countries such as Sri Lanka, Belarus and Ethiopia, where reserve levels are already low relative to external debt payments that are coming up or imports or as a share of gross domestic product.

Macroeconomic uncertainties are mounting globally after the Russia-Ukraine war, with commodity prices reaching record highs in recent weeks, stoking inflation around the globe.

The International Monetary Fund lowered its 2022 growth forecast for the global economy, with the Ukraine war severely denting economic prospects and rising inflation threatening to derail momentum.

The IMF now projects global growth at 3.6 per cent in 2022 and 2023, revised down 0.8 percentage points and 0.2 percentage points, respectively, from its January forecasts.

The US, the world’s largest economy, is also tightening monetary policy and is considering half-point interest rate increases to tame inflation, according to Federal Reserve chairman Jerome Powell.

“A 200 basis points shock to marginal borrowing costs would weaken the debt affordability metrics of emerging markets and frontier markets most, with their median interest/revenue increasing by 0.7 percentage points as compared to the no-shock baseline. The median impact on advanced economies is lower at 0.5 percentage points,” Moody’s said.

At a country level, sovereigns with an already high-interest bill and large gross borrowing requirements are most exposed to a 200 bps shock in marginal borrowing costs, including Sri Lanka, Egypt, Pakistan and Ghana, the rating agency said.

Advanced economies such as the US and Japan are also exposed to higher borrowing costs given their high refinancing needs.

However, the interest bill relative to revenue remains below 10 in both cases, indicating their low cost of debt and large funding pool, it said.

Sri Lanka is facing its worst financial crisis in more than 70 years amid low reserves of foreign currencies. It is seeking funding from the IMF and other countries such as India and China to cope with the crisis.

The Covid-19 crisis hit the country hard, leading to a loss of tourism revenue and strict lockdowns. Deep tax cuts in 2019 and the effects of the Covid-19 pandemic resulted in fiscal deficits of 11.4 per cent and 12.8 per cent of GDP in 2021 and 2020, respectively, raising public debt well above 100 per cent of GDP.

Egypt, the Arab world’s most populous country, is also suffering from rising import costs and energy prices, which have affected foreign currency reserves amid the Russia-Ukraine conflict.

The North African country's annual urban inflation rate rose to 8.8 per cent in February, the fastest in about three years, due to surging food prices.

To mitigate the economic shocks caused by supply chain disruptions and shore up foreign currency reserves, Egypt recently introduced a 130bn Egyptian pound ($7.1bn) relief package, raised interest rates, let its currency weaken sharply and asked for support from the IMF.

The country’s Gulf allies also pledged as much as $22bn to help the country to cope with the effects of the war in Ukraine.

“The depreciation shock is more relevant for frontier and emerging markets than for advanced economies because the latter mostly fund themselves in local currency,” Moody’s said.

“The exposure of emerging and frontier markets to adverse valuation effects has actually increased in the last four years, given the renewed rise in the median share of debt denominated in foreign currency.”

Among sovereigns without long-lasting pegged exchange rates, Suriname is expected to record the largest increase in its debt/GDP ratio from a 20 per cent depreciation shock, given its high initial debt stock and significant foreign currency share, which stood at more than 70 per cent in 2021, followed by Laos and Argentina.

Moody’s also said a drawdown in reserves would weaken coverage of coming external debt service payments among frontier and oil-importing Mena markets.

“An unanticipated drawdown of reserves of 2 per cent of [the] GDP would increase balance-of-payment risks for Sri Lanka, Belarus, Bahrain and Ethiopia, most given their already low foreign-exchange reserve buffers when measured in months of import cover,” it said.