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The Long Road Back: How Three Sovereigns Regained Investment-Grade Ratings After Defaulting

Of the sovereigns with investment-grade ratings, only three--Indonesia, Uruguay, and Cyprus--were in default (according to S&P Global Ratings Definitions) in the past (see Chart 1).  A missed payment caused one of Indonesia's three consecutive defaults (during 1999-2002). Indonesia's other two defaults, as well as those of Uruguay and Cyprus, were due to debt exchanges that we considered distressed.

Following the defaults, it took these countries five to 15 years to regain the investment-grade ratings.  Cyprus was the fastest to recover, partly because of the economic resilience that comes with its high per capita income. In addition, it had strong support from European partners that contributed to a fiscal adjustment of close to 10 percentage points of GDP between 2014 and 2017, availability of support to banks, and a concomitant improvement in the debt profile.

By contrast, Indonesia--with a much lower GDP per capita--took the longest (15 years) to regain investment grade. Successive governments undertook wide-ranging fiscal and economic reforms as well as changes in monetary policy to increase the sovereign's economic resilience.

Uruguay was in the middle (nine years). Its income is about half that of Cyprus but higher than that of Indonesia. The upgrades that led back to investment grade reflected the fruits of many years of good GDP growth (with a substantial contribution coming from foreign direct investment and from high prices for its commodity exports), important enhancements in the sovereign's debt profile to reduce vulnerability to external shocks, and stronger regulation in the financial sector.

Chart 1

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While the economic crises occurred in different regions and at various times, and they stemmed from unrelated events, there were some common features in both the paths to default and the climbs back to investment-grade.  While crises will continue to happen, we believe these countries have learned and built resilience from the weaknesses that made them more vulnerable in the past.

Chart 2

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Downward Spirals Stemmed From Underlying External Vulnerabilities

In all three cases, there were weaknesses in the sovereigns' external profiles, and these were amplified by negative external developments in a related country, ultimately leading to default.  In Indonesia, for example, the key underlying vulnerability was a fixed exchange rate that encouraged external borrowing and led to excessive exposure to foreign-currency liabilities for the government and the private sector. When the government of Thailand allowed its currency to float due to a lack of foreign exchange reserves to back its long-standing peg to the U.S. dollar in 1997, foreign investors began to withdraw their capital from the entire region, including from Indonesia. Loss of foreign exchange reserves forced the Indonesian government to allow its currency to depreciate, which in turn enlarged the debt burden and debt-service payments (as much of the debt was in foreign currency) for the public and private sectors.

Meanwhile, significant financial sector linkages with other countries--Argentina, in the case of Uruguay, and Greece in the case of Cyprus--were a key underlying vulnerability. In Uruguay, the crisis was triggered by the aftermath of a currency crisis in Argentina following the stark end of its policy of keeping a fixed exchange rate. The financial crisis in Argentina led to a large outflow of non-resident deposits in the Uruguayan financial sector (75% of them from Argentina), triggering a sharp decline in international reserves, which in 2002 fell to 25% of the 2001 level. The subsequent currency depreciation in Uruguay substantially enlarged the burden of external debt and debt service payments in a country with considerable foreign-currency exposure. In Cyprus, a rapid increase in non-resident deposits from Russia and other CIS jurisdictions (which increased short-term external debt to 5.7x GDP by 2010) led domestic banks to build up the balance-sheet exposure of their Greek subsidiaries to Greek government debt. This caused a systemic financial sector crisis when the Greek government defaulted on its debt stock in December 2012. The high exposure of Cypriot banks to Greek public-sector debt (that was restructured) and private-sector debt (that could not be repaid) led to substantial losses on their loan books. That, in turn, encouraged deposit flight, exacerbating these banks' liquidity problems.

In all cases, monetary response was limited by structural features.  In Indonesia, there was little room for an effective monetary response to the currency crisis due to reluctance to adjust a long-held fixed exchange rate or to raise domestic policy interest rates beyond already high levels (and worsen the economic contraction and financial sector contingent liabilities). In Uruguay, high dollarization in the banking sector limited the capacity to respond. A depreciating currency might have alleviated the shortage of dollars caused by the withdrawal of non-resident deposits but would also have damaged other sectors of the economy that were highly exposed to foreign-currency liabilities. As a member of the Economic and Monetary Union, Cyprus had less individual monetary flexibility, though this membership provided Cyprus with a lender of last resort (the European Central Bank), enabling the country to survive the prolonged external shock.

The crises ended up severely affecting economic growth, fiscal accounts, and debt levels.  All three countries had a crisis-related 5%-6% average annual economic contraction in the two years prior to default. This pressured fiscal accounts due to lower revenue collection, and it happened at a time when these countries faced higher debt-service payments from foreign-currency exposure (Indonesia and Uruguay) or a rapid increase in short-term external debt (Cyprus). The sovereigns' debt burden also increased as a consequence, exacerbated by government recapitalization of the financial sector and--in the case of Indonesia--some elements of the corporate sector as well.

A vulnerable debt composition and heightened rollover risk led to distressed debt exchanges.  In all three countries, net general government (GG) debt more than doubled in five years or less from 40% of GDP prior to default to about 90%-100% in the year of default. The composition of sovereign debt was characterized by high exposure to foreign currency in Indonesia (60%) and Uruguay (97%) and short-term external debt in the case of Cyprus (in 2012, 57% of its borrowing was short term). As a result of the crises, debt-service payments peaked.

Chart 3

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Relatively Benign Debt Exchange Conditions And Strong Policy Signals Supported Post-Default Market Access

There were no reductions in face value, and debt negotiations with private creditors were not acrimonious.  However, investors suffered losses in terms of net present value. This resulted from lack of compensation in the debt exchange due to extended maturities while interest rates remained virtually unchanged (see below for details). Interest rates were also below market rates at that time. We considered these debt exchange offers as distressed (based on our criteria), rather than purely opportunistic, because of the possible negative consequences for the sovereign's ability and willingness to service the original debt had the exchanges failed.

Maturities were extended by four to 10 years, providing substantial debt-service relief.  In the case of Indonesia, the restructuring of its syndicated loans was part of a broader debt exchange with the Paris Club (involving bilateral official debt) that stipulated comparability-of-treatment rules for private-sector creditors. The exchange aimed at improving prospects for the government's eventual return to the capital markets by sparing the Yankee bond. For Uruguay, the exchange included virtually all of the sovereign's foreign-currency bonds and resulted in a reduction in principal payments from US$2 billion to US$300 million over 2003-2007. The government was in active communication with bondholders and completed the process in two and a half months, with a participation rate of 93%. Cyprus received a €10 billion program with the EU, ECB, and IMF but restructured some local-law securities that fell outside the scope of program. The defaulted debt was mostly held by large domestic banks and had no collective-action clauses, which were included in the new notes.

Several common factors contributed to a favorable trend in creditworthiness after the debt default.  In all three countries, there was a commitment to policy changes that contributed to better economic performance and resilience, helping to gain access to financial markets within one year after the debt exchange for Uruguay, three years for Cyprus, and almost 10 years for Indonesia. International conditions of high liquidity also played an important role, as U.S. interest rates have averaged 1.6% since 2000, with somewhat higher rates between 2005 and 2008 and close to 0% between 2009 and 2015. Countries also wisely took advantage of headwinds in the post-default years, such as favorable terms of trade in Uruguay and Indonesia, to strengthen external liquidity.

Sovereigns' Debt-Exchange Conditions
Country Debt Conditions
Indonesia Syndicated loans for US$710 million No principal haircuts, extended maturities by approximately four years, and an unchanged interest rate. Also, Indonesia didn't default on its Yankee bond.
Uruguay Global and local law bonds in foreign currency for US$5.1 billion No principal haircut, extended maturities by five years or more, interest rates similar to those in original bond agreements, and cash payment.
Cyprus Local law securities for €1 billion No principal haircut, extended maturities by five to 10 years, and unchanged interest rate. Also, Cyprus did not default on any of its foreign law obligations.

Strengthening The Balance Sheet Requires Large Policy Efforts And Growth

All three countries showed institutional commitments to policies that increased resilience in the years following the default.  In Indonesia, the government committed to fiscal and economic reform, leading to strong public finances that are now a cornerstone of its investment-grade rating. This included some politically sensitive policies like fuel price hikes. At the same time, the central bank shifted to an inflation-targeting policy and achieved significant operational independence. Uruguay also lowered fiscal and external vulnerabilities through prudent macroeconomic policies in general, enhanced regulation in the financial sector, and material improvements in the debt structure due to active liability management. In Cyprus, the government's commitment to significant fiscal, financial sector, and structural reforms--along with assistance from its European partners in improving its debt profile--supported improved performance.

Economic dynamism stemmed from different pockets of growth amid limited availability of domestic credit following the crisis in the financial sector.  Between the default and the upgrade to investment grade, all three countries posted sustained real GDP growth of 5%-6% annually, on average. Indonesia's economy, which is highly dependent on domestic demand, grew at an average of 5.4% annually for 16 years (2002-2017). Economic policies encouraged the growth of domestic firms, especially small and medium-sized enterprises, while encouraging integration into global trade and capital markets as well as foreign investment in the financial and corporate sectors. FDI was modest immediately after the default crisis, deterred by perceptions of corruption, legal and labor market obstacles, red tape, and poor infrastructure, but it picked up after some years. Meanwhile, the Uruguayan economy grew 5.7% from 2004 and 2012 amid robust external performance during a commodity boom. It also benefited from the government's success in attracting a large investment project in the pulp and paper sector (Montes del Plata) in 2011, equivalent to 5% of GDP. As a result, GDP per capita increased by 4.5x, giving Uruguay one of the highest income levels in Latin America. Cyprus grew 5.4% on average between 2015 and 2018. While its financial sector did not contribute much to investment for several years, the economy prospered due to projects related to tourism, energy (solar thermal and hydrocarbon), and business services.

Chart 4

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Governments made fiscal adjustments to stabilize debt and improve their profiles.  For Uruguay and Cyprus, GG deficits fell to 2%-3% of GDP on average following the default, from peaks of 6% during the defaults. Indonesia ran balanced fiscal results pre and post default of 0.1% on average between 1999 and 2005. Economic growth contributed to revenue recovery, while governments showed commitment to fiscal discipline and realistic budgeting. This included politically costly decisions, such as the application of spending caps, subsidy reforms, a reduction in the public-sector wage bill, and--in some cases--pension outlays. Cyprus also privatized some state-owned enterprises, which was part of the program with the IMF and ESM (European Stability Mechanism). Meanwhile, the weight of interest payments that peaked with the defaults decreased markedly following debt restructurings and revenue recovery. Along with fiscal improvement, debt levels lowered (Indonesia and Uruguay) or stabilized (Cyprus), with increased resilience in its composition in all cases (see the Debt section below).

The external position improved, and international reserves piled up.  Narrow net external debt in terms of current account receipts (CARs) decreased markedly and external liquidity improved because of higher exports, while fiscal adjustments and FDI contained the growth of external debt. Uruguay took advantage of years of booming commodity exports to strengthen its public finances, boost external liquidity, and create stronger economic foundations to withstand the strains of lower commodity prices in future (in contrast with many net commodity exporters that were less prepared for the downturn in commodity prices). It also strengthened trade links beyond its region. In Indonesia, the depreciation of the exchange rate improved the current account, while policy measures to discourage short-term external borrowing were implemented, and international reserves were accumulated, increasing buffers against volatility in capital flows. External debt also decreased in Cyprus but was above that of Uruguay and Indonesia, given that a large part was explained by Eurosystem financing of the Bank of Cyprus, the largest domestic commercial bank.

Chart 5

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Debt Levels Matter, But Debt Composition Could Matter More

Following the crisis, debt burdens fell or stabilized on the back of improved fiscal performance and economic growth.  This was key, as rollover risk and risks on the flow side more generally--from higher interest rates, for example--worsen with a higher debt burden. While debt decreased markedly in Indonesia and Uruguay, Cyprus regained an investment-grade rating with the same debt burden as in its default years. There are two reasons for this: 1) Other factors support the rating on Cyprus, such as relatively high income levels ($33,000 compared with $18,000 in Uruguay and $5,000 in Indonesia), institutional strengths, and high fiscal flexibility. 2) The improvement in the composition and profile of the debt lowered default risks markedly.

Material efforts to improve debt composition were key in increasing balance-sheet resilience.  Improvement in debt composition was a key factor as the three countries were raised to investment grade. Indonesia shifted the government borrowing mix toward local-currency funds, and foreign-currency exposure fell to 40% of sovereign debt by 2016. Effective debt management significantly reduced the risks in Uruguay's debt profile; it replaced IMF maturing debt with long-term lower-cost capital-market debt, which significantly smoothed the amortization profile and lowered rollover risk. Meanwhile exposure to foreign currency decreased to 66% of total debt by 2010 and 55% by 2015, and a higher portion was at fixed rates. Debt composition in Cyprus became much more favorable, in large part because of external support; 40% of debt in 2016 was from ESM and IMF at concessional interest rates and long maturities (no redemptions until 2025) while Cyprus regained access to the capital market quickly relative to other post-default governments. Debt management has been proactive, and Cyprus held an operation to repay some expensive debt ahead of schedule.

Chart 6

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Chart 7

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As the experiences of the three countries show, strong policy efforts as well as structural reform played a key role in going back to investment grade. Prior to their crises, net GG debt was modest at 40% of GDP, and fiscal deficits were often moderate. As the crisis occurred, fiscal performance deteriorated as the economy came under strain. The weakening of public finances was an outcome of the crisis, not the cause. External factors, GDP growth, monetary policy flexibility (including exchange rate flexibility), and the health of the financial system proved to be important factors in assessing the vulnerabilities that led to the crisis as well as in the strengthening of economic resilience as the countries embarked on the path to investment grade.

Appendix

Chart 8

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This report does not constitute a rating action.

Primary Credit Analyst:Constanza M Perez Aquino, Buenos Aires + 54 11 4891 2167;
constanza.perez.aquino@spglobal.com
Secondary Contacts:Nicole Schmidt, Mexico City +52 5550814451;
nicole.schmidt@spglobal.com
Alina Czerniawski, Buenos Aires +54 1148912194;
alina.czerniawski@spglobal.com
Joydeep Mukherji, New York + 1 (212) 438 7351;
joydeep.mukherji@spglobal.com
Additional Contacts:Frank Gill, Madrid + 34 91 788 7213;
frank.gill@spglobal.com
Sebastien Boreux, Paris + 33 14 075 2598;
sebastien.boreux@spglobal.com
Andrew Wood, Singapore + 65 6239 6315;
andrew.wood@spglobal.com

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