Why Everyone’s Talking About… Sovereign Risk
Ruminating about global tensions in a 2021 speech at Davos, Russian President Vladimir Putin said: “The situation can develop unpredictably and uncontrollably if, of course, nothing is done to prevent this from happening. Moreover, there’s a chance of a real breakdown in global development that’s fraught with a fight of all against all.”1
Those words, unfortunately, ring all to true today. Around the world, geopolitical, environmental, and economic forces are combining to breed volatility and disrupt growth. A survey of professional investors by Bank of America found that worsening geopolitics is the biggest tail risk in markets for 20242. With uncertainty lurking around every corner, global leaders are having to contend with the fallout of war and ongoing political upheaval – as well as grappling with the increasing impacts of climate change.
Indeed, many of these factors are contributing to heightened sovereign risk – whereby a government fails to make debt repayments or honour a loan agreement3 . Several developing countries and emerging economies entered default in 20224 , while over 80% of the $10 trillion rise in global debt in the first half of 2023 came from developed countries – reaching a record $307 trillion5. In addition, countries that fail to curb their carbon emissions may see rising debt-servicing costs – as climate change potentially increases the cost of sovereign and corporate debt worldwide6.
What’s more, 2024 is an election year – and not just in the US, the world’s largest economy. Russia, India and the UK are all expected to hold decisive elections in 2024, and situations can develop swiftly and substantially at the policymaker level: take UK prime minister Rishi Sunak’s recent major cabinet reshuffle, which has seen the return of former PM David Cameron as foreign secretary. While few of us saw that coming, we might well expect plenty more surprises ahead – and the repercussions will be felt both domestically and internationally.
Whether it’s worries over a regime change, the threat of government debt trajectories to macroeconomic and financial stability, the long-term liabilities posed by climate change, or the immediate risks of war, there’s plenty for investors to grapple with when thinking about geopolitics and sovereign risk in 2024.
GLOSSARY
1 Source: https://www.themoscowtimes.com/2021/01/27/geopolitics-sanctions-and-social-media-putins-davos-speech-in-quotes-a72752
2 Source: https://markets.businessinsider.com/news/stocks/bofa-geopolitics-war-inflation-fed-interest-rates-tightening-tail-risk-2023-11
3 Source: https://economictimes.indiatimes.com/definition/sovereign-risk
4 Source: https://www.reuters.com/markets/developing-countries-facing-debt-crisis-2023-04-05/
5 Source: https://www.iif.com/portals/0/Files/content/Global%20Debt%20Monitor_Sept2023_vf.pdf?link_id=2&can_id=c6f64a9082f2ba9fff41e722c8113eec&
6 Source : https://www.uea.ac.uk/about/news/article/study-reveals-the-increasing-cost-of-debt-caused-by-climate-change
7 Source: https://www.theguardian.com/business/2023/oct/13/jp-morgan-jamie-dimon-economy-impact-israel-hamas-war
8 Source: https://www.nytimes.com/2023/11/09/business/energy-environment/oil-price-israel-gaza.html
9 Source: https://business.bofa.com/en-us/content/market-strategies-insights/weekly-market-recap-report.html
10 Source: https://www.brunswickgroup.com/media/11259/geopolitical_eightelections2024_091523_final.pdf
11 Source: https://www.politico.com/f/?id=0000018b-c6e8-d7df-abbb-efebf1c00000&nname=playbook&nid=0000014f-1646-d88f-a1cf-5f46b7bd0000&nrid=d2fc75da-8760-41da-a500-a8101b2309d5&nlid=630318
12 Source: https://www.forbes.com/advisor/investing/how-do-elections-affect-the-stock-market/
13 Source: https://www.unep.org/news-and-stories/press-release/impacts-accelerate-adapting-climate-change-must-become-global
14 Source: https://www.irena.org/Digital-Report/World-Energy-Transitions-Outlook-2022
15 Source: https://atradius.co.uk/reports/economic-research-energy-transition-not-a-panacea-for-fuel-importers.html
16 Source: https://edition.cnn.com/2023/11/07/business/china-bri-developing-countries-overdue-debt-intl-hnk/index.html
17 Source: https://www.reuters.com/markets/china-spent-240-bln-bailing-out-belt-road-countries-study-2023-03-27/
18 Source: https://www.reuters.com/world/china/chinas-troubled-property-sector-face-more-debt-defaults-2023-10-20/
19 Source: https://www.wilsoncenter.org/blog-post/much-world-facing-debt-distress
20 Source: https://www.wilsoncenter.org/blog-post/much-world-facing-debt-distress
21 Source: https://www.imf.org/en/Blogs/Articles/2023/09/13/global-debt-is-returning-to-its-rising-trend
22 Source: https://www.fitchratings.com/research/sovereigns/fitch-downgrades-united-states-long-term-ratings-to-aa-from-aaa-outlook-stable-01-08-2023
Those words, unfortunately, ring all to true today. Around the world, geopolitical, environmental, and economic forces are combining to breed volatility and disrupt growth. A survey of professional investors by Bank of America found that worsening geopolitics is the biggest tail risk in markets for 20242. With uncertainty lurking around every corner, global leaders are having to contend with the fallout of war and ongoing political upheaval – as well as grappling with the increasing impacts of climate change.
Indeed, many of these factors are contributing to heightened sovereign risk – whereby a government fails to make debt repayments or honour a loan agreement3 . Several developing countries and emerging economies entered default in 20224 , while over 80% of the $10 trillion rise in global debt in the first half of 2023 came from developed countries – reaching a record $307 trillion5. In addition, countries that fail to curb their carbon emissions may see rising debt-servicing costs – as climate change potentially increases the cost of sovereign and corporate debt worldwide6.
What’s more, 2024 is an election year – and not just in the US, the world’s largest economy. Russia, India and the UK are all expected to hold decisive elections in 2024, and situations can develop swiftly and substantially at the policymaker level: take UK prime minister Rishi Sunak’s recent major cabinet reshuffle, which has seen the return of former PM David Cameron as foreign secretary. While few of us saw that coming, we might well expect plenty more surprises ahead – and the repercussions will be felt both domestically and internationally.
Whether it’s worries over a regime change, the threat of government debt trajectories to macroeconomic and financial stability, the long-term liabilities posed by climate change, or the immediate risks of war, there’s plenty for investors to grapple with when thinking about geopolitics and sovereign risk in 2024.
First, there are major armed conflicts. Russia’s invasion of Ukraine continues to grimly rumble on and the conflict in Gaza is intensifying at an alarming pace. According to JP Morgan boss Jamie Dimon, the latter has “far-reaching impacts” on energy prices, food costs, international trade, and diplomatic ties7. We only need to look at how the Russian invasion of Ukraine caused energy prices to spike around the world to understand how armed aggression can disrupt global economics.
Investors are becoming more nervous about the Middle Eastern conflict, too, which has already involved Lebanon, Syria and the US. Commodity prices have started to rally, with investors flocking to the traditional safe haven of gold and oil prices rising amid concerns about supply disruption. Though oil prices rallies have abated as disruption fears have eased8 there are concerns among investors about how this could quickly draw in other nations. The major disruption, and cost, of war has clear ramifications for countries’ balance sheets and the role that sovereign debt plays.
Moreover, if the conflict in Gaza were to spread, the impact on energy infrastructure could see a barrel of crude oil push past $150 – potentially tipping the US economy into recession9.
Investors are becoming more nervous about the Middle Eastern conflict, too, which has already involved Lebanon, Syria and the US. Commodity prices have started to rally, with investors flocking to the traditional safe haven of gold and oil prices rising amid concerns about supply disruption. Though oil prices rallies have abated as disruption fears have eased8 there are concerns among investors about how this could quickly draw in other nations. The major disruption, and cost, of war has clear ramifications for countries’ balance sheets and the role that sovereign debt plays.
Moreover, if the conflict in Gaza were to spread, the impact on energy infrastructure could see a barrel of crude oil push past $150 – potentially tipping the US economy into recession9.
In 2024, countries making up over half of global GDP will undergo decisive elections: in Taiwan, Indonesia, Russia, India, South Africa, UK (possibly January 2025), the EU and the US among others10. Each election brings the possibility of change, potentially meaning new leaders will emerge with new attitudes towards economic development and international relations. It means further uncertainty, arguably the biggest impediment to investment.
Globally, a number of major elections could upset international relations, particularly if protectionist governments are voted into power that prioritise narrow domestic economic interests over international collaboration. There are also sector-specific concerns. For example, if the US were to vote for a Republican president in 2024, it could mean a reversal of pro-ESG policies and potentially an end to unprecedented support for renewable energy, which would have widespread impacts on portfolios.
In particular, the next presidential election in the US already has investors talking as – despite numerous legal hearings – former president Donald Trump is being widely touted as having a good chance of re-election. One survey found that if Trump went head-to-head with incumbent Joe Biden now, the former would win the electoral vote by 292 votes to 24611.
Such elections, and the uncertainty they bring markets, can have real and quantifiable impacts on portfolios. One survey found that in the year leading up to presidential elections, US equities gained an average of under 6% which is against the usual return of over 8%. Bond yields are hit too, delivering 6.5% in election years as opposed to the 7.5% they usually deliver12.
This suggests that, with elections in so many major economies aligning next year, navigating this political upheaval could be challenging for investors.
Globally, a number of major elections could upset international relations, particularly if protectionist governments are voted into power that prioritise narrow domestic economic interests over international collaboration. There are also sector-specific concerns. For example, if the US were to vote for a Republican president in 2024, it could mean a reversal of pro-ESG policies and potentially an end to unprecedented support for renewable energy, which would have widespread impacts on portfolios.
In particular, the next presidential election in the US already has investors talking as – despite numerous legal hearings – former president Donald Trump is being widely touted as having a good chance of re-election. One survey found that if Trump went head-to-head with incumbent Joe Biden now, the former would win the electoral vote by 292 votes to 24611.
Such elections, and the uncertainty they bring markets, can have real and quantifiable impacts on portfolios. One survey found that in the year leading up to presidential elections, US equities gained an average of under 6% which is against the usual return of over 8%. Bond yields are hit too, delivering 6.5% in election years as opposed to the 7.5% they usually deliver12.
This suggests that, with elections in so many major economies aligning next year, navigating this political upheaval could be challenging for investors.
Climate change is putting the global economy under greater pressure. More frequent events with greater severity – such as wildfires, floods, droughts, and storms – are causing billions in damage and disruption.
Countries are having to spend more to recover from these events and significant investment is needed to prepare for the ‘new normal’ of their greater regularity. It is calculated that climate adaptation will cost economies up to $340 billion a year by 2030 and $565 billion a year by 2050, with the majority of this being funded through sovereign debt13.
Climate risk isn’t only about major, high-profile events – it also involves very real day-to-day challenges for countries. For instance, climate change can lead to water scarcity and higher localised temperatures that impact agriculture, which in turn increase food scarcity.
For investors, reacting to climate risk isn’t as simple as allocating away from a region regularly being hit by adverse weather. Instead, it is about understanding how climate change could impact countries’ economic development and energy transition plans. This could directly influence the outlook for renewable energy and infrastructure investments, while likely redrawing energy relationships between nations.
With around 80% of the world’s population living in countries classified as net energy importers14, renewable energy offers these nations greater self-sufficiency. This process has already started and, for the largest net fuel importing economies, the net fuel import bill has dropped from an average of 8.4% of GDP in 2015 to 6.2% of GDP in 202115.
Countries are having to spend more to recover from these events and significant investment is needed to prepare for the ‘new normal’ of their greater regularity. It is calculated that climate adaptation will cost economies up to $340 billion a year by 2030 and $565 billion a year by 2050, with the majority of this being funded through sovereign debt13.
Climate risk isn’t only about major, high-profile events – it also involves very real day-to-day challenges for countries. For instance, climate change can lead to water scarcity and higher localised temperatures that impact agriculture, which in turn increase food scarcity.
For investors, reacting to climate risk isn’t as simple as allocating away from a region regularly being hit by adverse weather. Instead, it is about understanding how climate change could impact countries’ economic development and energy transition plans. This could directly influence the outlook for renewable energy and infrastructure investments, while likely redrawing energy relationships between nations.
With around 80% of the world’s population living in countries classified as net energy importers14, renewable energy offers these nations greater self-sufficiency. This process has already started and, for the largest net fuel importing economies, the net fuel import bill has dropped from an average of 8.4% of GDP in 2015 to 6.2% of GDP in 202115.
This year marks the 10th anniversary of China’s Belt and Road Initiative (BRI), a colossal programme of infrastructure investments that spans the world and has been described as the ‘new Silk Road’.
However, the level of lending involved has highlighted the challenging position China now finds itself in with $1.1 trillion owed to China from this debt16. The BRI has involved several low- and middle-income countries failing to meet scheduled repayments, forcing China to issue more debt and even partially forgive some earlier rounds.
It was revealed that Chinese loans to countries in debt distress soared from 5% of its overseas lending activity in 2010 to 60% in 2022. This meant China spent $240 billion bailing out countries it had lent money to17.
At the same time, China’s domestic economy has been struggling to recover from years of its aggressive ‘Zero Covid’ policy. Consumption has been sluggish and the country’s property sector is in deep trouble, with developments grinding to a standstill and potential purchasers unwilling to buy. The Chinese government has been working to support this sector but $124.5 billion of bonds are now in default within the country’s $175 billion property dollar-bond sector18.
Investors should keep in mind that China, the second largest economy in the world, is increasingly issuing debt on two fronts – a factor that may bring about greater volatility in the future.
However, the level of lending involved has highlighted the challenging position China now finds itself in with $1.1 trillion owed to China from this debt16. The BRI has involved several low- and middle-income countries failing to meet scheduled repayments, forcing China to issue more debt and even partially forgive some earlier rounds.
It was revealed that Chinese loans to countries in debt distress soared from 5% of its overseas lending activity in 2010 to 60% in 2022. This meant China spent $240 billion bailing out countries it had lent money to17.
At the same time, China’s domestic economy has been struggling to recover from years of its aggressive ‘Zero Covid’ policy. Consumption has been sluggish and the country’s property sector is in deep trouble, with developments grinding to a standstill and potential purchasers unwilling to buy. The Chinese government has been working to support this sector but $124.5 billion of bonds are now in default within the country’s $175 billion property dollar-bond sector18.
Investors should keep in mind that China, the second largest economy in the world, is increasingly issuing debt on two fronts – a factor that may bring about greater volatility in the future.
Many countries are in varying levels of debt distress and struggling to fulfil their obligations. A study earlier in 2023 found that 60% of low-income countries, and at least 25% of middle-income countries, were in this state19. Although sovereign debt has been growing since the 2008 financial crisis, borrowing significantly accelerated in 2020.
The Covid-19 pandemic forced many governments to increase borrowing to keep their economies afloat during repeated lockdowns. Though there has been some economic recovery since, the fallout of Russia’s invasion of Ukraine has disrupted global commodity markets and the resulting higher prices acted as a further economic headwind.
Meanwhile, many central banks have raised interest rates in a bid to fight unusually high inflation. While this has made government debt cheaper to repay, it is putting the poorest countries that need to raise new debt under pressure. Over the next five years, it is expected that this could cost developing countries as much as $2.5 trillion20.
There are signs that this debt spiral is leading towards a full-blown sovereign debt crisis. The IMF recently revealed that in 2022 global debt stood at 238% of global GDP, or $235 trillion of outstanding debt21.
The UN agency has flagged concerns around the sustainability of this debt and called for governments to take “urgent steps” to reduce debt vulnerabilities and reverse long-term debt trends21. It issued its warning based on 2022 data – since then more debt has been issued, the Gaza conflict began and sovereign risk has generally become more pronounced.
One major development which highlights how challenging sovereign debt markets can be was Fitch Ratings’ August downgrade of US sovereign debt from AAA to AA+22. This was done in anticipation of “expected fiscal deterioration” over the next three years. If this is happening in the world’s biggest economy, it does not bode well for much smaller economies that are still developing.
The Covid-19 pandemic forced many governments to increase borrowing to keep their economies afloat during repeated lockdowns. Though there has been some economic recovery since, the fallout of Russia’s invasion of Ukraine has disrupted global commodity markets and the resulting higher prices acted as a further economic headwind.
Meanwhile, many central banks have raised interest rates in a bid to fight unusually high inflation. While this has made government debt cheaper to repay, it is putting the poorest countries that need to raise new debt under pressure. Over the next five years, it is expected that this could cost developing countries as much as $2.5 trillion20.
There are signs that this debt spiral is leading towards a full-blown sovereign debt crisis. The IMF recently revealed that in 2022 global debt stood at 238% of global GDP, or $235 trillion of outstanding debt21.
The UN agency has flagged concerns around the sustainability of this debt and called for governments to take “urgent steps” to reduce debt vulnerabilities and reverse long-term debt trends21. It issued its warning based on 2022 data – since then more debt has been issued, the Gaza conflict began and sovereign risk has generally become more pronounced.
One major development which highlights how challenging sovereign debt markets can be was Fitch Ratings’ August downgrade of US sovereign debt from AAA to AA+22. This was done in anticipation of “expected fiscal deterioration” over the next three years. If this is happening in the world’s biggest economy, it does not bode well for much smaller economies that are still developing.
- Bilateral lender – A loan arrangement between a single lender and a single borrower.
- Davos – Annual conference for the World Economic Forum, hosting many political and corporate leaders, named after the Swiss town, where it takes place.
- Debt distress – When a country is unable to fulfil its financial obligations and debt restructuring is required.
- Economic headwind – A factor or event that reduces the ability of a nation’s economy to grow.
- GDP – Gross Domestic Product, or the total market value of all finished goods and services produced within a country’s borders.
- IMF – The International Monetary Fund, a UN institution that is tasked with overseeing the stability of the world’s economic system.
- Sovereign risk – The risk that a foreign government will default on its bonds.
2 Source: https://markets.businessinsider.com/news/stocks/bofa-geopolitics-war-inflation-fed-interest-rates-tightening-tail-risk-2023-11
3 Source: https://economictimes.indiatimes.com/definition/sovereign-risk
4 Source: https://www.reuters.com/markets/developing-countries-facing-debt-crisis-2023-04-05/
5 Source: https://www.iif.com/portals/0/Files/content/Global%20Debt%20Monitor_Sept2023_vf.pdf?link_id=2&can_id=c6f64a9082f2ba9fff41e722c8113eec&
6 Source : https://www.uea.ac.uk/about/news/article/study-reveals-the-increasing-cost-of-debt-caused-by-climate-change
7 Source: https://www.theguardian.com/business/2023/oct/13/jp-morgan-jamie-dimon-economy-impact-israel-hamas-war
8 Source: https://www.nytimes.com/2023/11/09/business/energy-environment/oil-price-israel-gaza.html
9 Source: https://business.bofa.com/en-us/content/market-strategies-insights/weekly-market-recap-report.html
10 Source: https://www.brunswickgroup.com/media/11259/geopolitical_eightelections2024_091523_final.pdf
11 Source: https://www.politico.com/f/?id=0000018b-c6e8-d7df-abbb-efebf1c00000&nname=playbook&nid=0000014f-1646-d88f-a1cf-5f46b7bd0000&nrid=d2fc75da-8760-41da-a500-a8101b2309d5&nlid=630318
12 Source: https://www.forbes.com/advisor/investing/how-do-elections-affect-the-stock-market/
13 Source: https://www.unep.org/news-and-stories/press-release/impacts-accelerate-adapting-climate-change-must-become-global
14 Source: https://www.irena.org/Digital-Report/World-Energy-Transitions-Outlook-2022
15 Source: https://atradius.co.uk/reports/economic-research-energy-transition-not-a-panacea-for-fuel-importers.html
16 Source: https://edition.cnn.com/2023/11/07/business/china-bri-developing-countries-overdue-debt-intl-hnk/index.html
17 Source: https://www.reuters.com/markets/china-spent-240-bln-bailing-out-belt-road-countries-study-2023-03-27/
18 Source: https://www.reuters.com/world/china/chinas-troubled-property-sector-face-more-debt-defaults-2023-10-20/
19 Source: https://www.wilsoncenter.org/blog-post/much-world-facing-debt-distress
20 Source: https://www.wilsoncenter.org/blog-post/much-world-facing-debt-distress
21 Source: https://www.imf.org/en/Blogs/Articles/2023/09/13/global-debt-is-returning-to-its-rising-trend
22 Source: https://www.fitchratings.com/research/sovereigns/fitch-downgrades-united-states-long-term-ratings-to-aa-from-aaa-outlook-stable-01-08-2023
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