The global debt distress – fallout from rising interest rates

The era of cheap financing is over. After a decade of low interest rates, central banks are hiking rates to contain the rapidly rising inflation sparked by expansionary fiscal policy during the COVID-19 crisis and higher commodity prices as a fallout from the war in Ukraine. These rate hikes come at a time when public debt levels are at historic highs. The low-interest rate environment in place since the global financial crisis of 2008–09 had provided an opportunity for governments to raise their debt to record levels, which the emergency fiscal measures actioned during the pandemic only added to. With higher rates, the costs of debt servicing (paying interest on existing debt) and of securing new debt have increased substantially. The very large public debt bills remain sensitive to further interest rate hikes, bringing into question the sustainability of sovereign debt worldwide. 

Emerging markets are relatively more exposed to rising interest rates, due to higher macroeconomic vulnerability and shorter-dated debt stocks that need to be rolled over in an environment of higher capital costs.¹ Countries with a high proportion of US dollar-denominated debt are particularly vulnerable on account of dollar strength. 

Another factor that makes emerging markets more vulnerable to rising debt costs is creditor diversity and opacity of term loans. Over the past decade, the range of creditors of public debt in emerging economies has broadened. It now includes quasi-sovereign entities and also the private sector participants like commodity traders and producers.² In 2020, private-sector creditors accounted for nearly 62% of emerging markets’ external debt, up from 43% in 2000.³ Meanwhile, external debt of emerging markets as share of GDP grew from 23% in 2008, to 31% in 2021. This represents a shift towards arguably more expensive and risky sources of funds than in the past, such as from international private and commercial lenders.⁴ With that shift, creditor companies globally may have become more exposed to a potential debt crisis in emerging markets, with contagion spreading systemic vulnerability across large banks and private creditors. Meanwhile, China has become a large bilateral creditor to many emerging markets. Where public debt restructuring is needed, this could further strain geopolitical dynamics, as debt may be leveraged to pull emerging economies into the growing polarisation between large powers.⁵ 

In advanced markets – where public debt levels are also at historically high levels – rising debt servicing obligations may constrict future economic growth, as a larger share of GDP goes to debt servicing payments and less to new growth-oriented investment or anti-cyclical fiscal policies.⁶  Low levels of investment, coupled with failing productivity in advanced markets could spell rising unemployment and potentially increased social unrest. As a result, credit and surety (C&S), property, business interruption (BI) and political violence (PV) covers may be triggered. A weakening in public health services investment could also reflect in poorer L&H outcomes.

The build-up of sovereign debt poses significant risks to global resilience, with over-indebted governments potentially unable to provide public goods and social safety nets.⁷ This situation may be exacerbated by the ongoing cost of living crisis, as the rising cost of food and energy reduces consumer purchasing power and prices some households out of risk protection solutions. Combined, these factors could imply that insurance affordability will be threatened at a time when societal resilience has already been undermined.⁸ Under these conditions, the global economy is ill-prepared for a next shock event.