Global Polarization and International Bond Market Premia

Did you think that the problem of modernization went away?

Daniel Munevar has just published a fascinating study on the international bond market debt of middle and low income countries. He has collated and made public data from Refinitiv on 549 outstanding sovereign bonds denominated in hard currencies with a nominal value of $691bn. He found that the vast bulk of the debt is denominated in dollars and placed in either New York or London. He documents that the largest underwriters are Western megabanks led by Citi, and the largest holders of these risky fixed-income securities are American asset managers led by — no surprise here — BlackRock. I urge you to read the full report.

Munevar finds that these countries will have to pay $330bn in debt service on these bonds worth $691bn. That’s an astonishing number. It suggests that the borrowing costs faced by these Third World sovereigns are very, very high. What explains these high borrowing costs? What governs the size of the pound of flesh that global bondholders demand for lending money to Third World sovereigns? These are questions of some importance in light of the financing needs of the Third World, particularly with respect to the global energy transition; not to mention, development.

He does not report data on yields. But he does report coupon rates. On standard fixed-rate semi-annual coupon bonds, the coupon rate is the payment you commit to make biannually when you borrow money on the bond market — it is unaffected by market developments after the placement of the debt. Yields contain more up to date information on the borrowing cost at the margin — they’re also more relevant since you can almost always refinance by issuing fresh debt at current rates and use the proceeds to retire outstanding bonds. But if one is interested in understanding the cross-section of borrowing costs, instead of the time-variation, then recent coupon rates are a more or less satisfactory substitute for yields.

Here we look at the cross-section of the coupon rates of these EM sovereign bonds. Munevar has a scatter plot in the report that shows that coupon rates are a function of ratings. (Note that he uses non-standard country codes.) But that’s only a proximate answer. One immediately asks: what then drives the ratings of these sovereigns?

Instead of looking at the proximate correlates of coupon rates, we shall look at ultimate correlates. When global banks underwrite Third World sovereign debt, they must decide on the coupon rate they must offer to bond investors, largely patient intermediaries like institutional asset managers. That depends in turn on the perceived risk of default on the debt. It is also affected by the risk premia or investor compensation available elsewhere for similar credit risks. Put another way, the debt of Third World sovereigns competes with other high risk fixed-income securities.

To deal with the second point first, risk premia are a function of the global financial cycle. We have previously shown how to construct a highly-informative index of financial conditions or risk appetite — when risk appetite is high, risk premia are low and vice-versa. Here’s the updated graph of the global financial cycle as of last week.

The global financial cycle governs the time-variation of risk premia, including the international borrowing costs faced by Third World sovereigns. What governs the cross-section of sovereign financing costs is credit risk perception by center country financial intermediaries. In what follows, we’ll document that these risk perceptions are, in turn, a function of relative levels of modernization of the nations concerned.

The universality of the modernization process has been challenged by antiracist scholars. But to anyone familiar with the covariation of mortality, morbidity, fertility, literary, education, corruption, state capacity, income and wealth, there can hardly be any doubt about three facts. First, that the nations of earth are differentially-situated with respect to their degree of development as measured by literally any socioeconomic indicator. Second, that all societies are on the same developmental path: child mortality rates are falling world wide, as are, not coincidently, fertility rates; income and wealth are rising in most poor nations; with few exceptions, life expectancy is rising, and mortality and morbidity rates are falling; populations are getting more literate and more educated; and even if corruption is endemic in too many societies, state capacity too is improving. Third, the developing nations of the world are again differentially-situated with respect to the rate at which they are closing in on the advanced nations across the whole spectrum of socioeconomic indicators.

This combined and uneven development of the world strongly governs the risk perceptions of center country financial intermediaries when they underwrite and finance the borrowing of Third World sovereigns.

We obtain data from INFORM risk indices. We merge the Munevar data on coupon rates with the risk indices on iso3 country codes. To begin at the most basic level, we find that coupon rates are correlated with lack of state capacity (r = 0.36, P < 0.001).

Coupon rates, and hence the borrowing costs of Third World sovereigns, are even more strongly correlated with the Human Development Index (r = 0.56, P < 0.001). In fact, of the almost one hundred correlates I examined, the HDI comes very close to the top in the degree of correlation.

Countries that are more vulnerable to epidemiological risks, food scarcity, and natural disasters have to pay more to access global capital markets. The Social Vulnerability Index is almost as strongly correlated with coupon rates as the HDI (r = 0.53, P < 0.001).

Other major correlates of the borrowing costs of Third World sovereigns are the percentage of internet users (r = -0.61, P < 0.001), per capita health expenditures (r = -0.56, P < 0.001), the quality of communications (r = 0.54, P < 0.001), the quality of infrastructure (r = 0.51, P < 0.001), the multidimensional poverty index (r = 0.46, P < 0.001), tropical disease burdens (r = 0.45, P < 0.001), and so on. The next table displays the top correlates of coupon rates.

The borrowing costs faced by Third World sovereigns are thus demonstrably a function of overall development and institutional competence.

The bottom line is that the problem of modernization has not gone away. In fact, it has returned with unprecedented urgency with the climate crisis. The advanced nations of the world want a global energy transition. The Third World states have more urgent priorities — like ensuring access to potable water. Moreover, given the limited institutional capacity and the scale of the challenges they face, a rapid energy transition may very well be beyond their present capabilities. Before long, this tension is going to create a demand for intervention-in-depth on the periphery of the world economy, with the attendant risk of neocolonialism.

The multilateral institutions have settled on a strategy of derisking to lower the financing costs for Third World borrowers. Daniela Gabor has strongly criticized this development, calling it the ‘Wall Street Consensus’. What exactly is the alternative? — I asked her at the JFI Roundtable on our proposal for a standalone ratings agency and US guarantees for prime green bonds. She said she didn’t have one. But she was underselling her case. She does want to see a global institutional structure for green development finance — one whose principal beneficiaries are not private financial intermediaries but rather the developing countries themselves. This social democratic vision is in deep tension with the structures of global financial intermediation as they exist at this moment in history. The question is whether there is enough time to win the political battles to bring about the world she wants. Or whether we must work with that we’ve got given the urgency of the task at hand. I’d be happy to see her vision realized. But we can’t make the perfect the enemy of the good.

Munevar wants ‘a statutory approach for private credit participation in debt relief under a multilateral sovereign debt workout mechanism’. Such a mechanism, he says, ‘is vital to address the structural power imbalance between creditors and debtors’ that he compares to ‘the struggle between an ant and a pack of elephants.’ That some sort of global institutional mechanism of sovereign debt restructuring is necessary has been obvious, particularly since the Never Ending Greek Debt-Slavery Saga. We should, however, be careful that an institutional mechanism of debt relief does not end up hurting developing nations by increasing their borrowing costs.

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