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Capital costs are rising, reflecting reduced high-income country risks

Not only have developing-country stock markets underperformed high-income stock markets, developing country sovereign credit default swap (CDS) rates and yields (figure 3) have been rising, despite the improved ratings of developing countries, and strong investor appetite for developing-country bonds.FN2

Figure 3
Developing country borrowing costs have risen but remain below historical averages
Figure 3
Source: World Bank, JP Morgan

Rising spreads, even as demand is strong and growing, may reflect a welcome and ultimately healthy improvement in market perceptions of the riskiness of investing in high-income countries. Part of the decline in developing-country risk premiums over the past five years was due to the increased riskiness of high-income country debt.FN3 Now that those risks have receded, investors may be shifting their portfolios back into high-income country assets, resulting in an increase in developing-country yields and spreads and better stock-market performance in high-income countries.

These developments may also reflect concern on the part of investors about inflation of asset prices in some developing countries (such as Brazil, Indonesia, Lao PDR, Philippines, Thailand, and Turkey) and the recent easing of commodity prices. Risk premia could have risen because high asset prices have been interpreted as a harbinger of sharp future correction; or if an expectation of lower commodity prices had raise concerns about future government revenues and governments’ capacity to repay existing debt and spending programs.

2. Traditionally, risk premiums are measured as the difference between developing-country yields or CDS rates and those of similar U.S. assets, with the idea that the U.S. assets proxy for the risk-free rate of return. As the crisis hit, the riskiness of U.S. financial assets clearly went up, even if yields did not, either in the short run because of flight-to-quality effects or later because of quantitative easing. At the same time, spreads on developing-country financial assets declined. Only part of that decline can be explained by improved credit quality (IMF 2013b), the rest being explained by the increased riskiness of the base rate and the reduced cost of credit.

3. Since January 2013, 10 developing-country borrowers have been upgraded and only six downgraded. In addition, over the past 18 months, eight developing countries (or developing-country governments)—Angola, Bolivia, Honduras, Mongolia, Paraguay, Rwanda, Tanzania, and Zambia—have issued bonds for the first time (in Bolivia’s case, for the first time in more than 90 years). Since 2010, 14 countries have entered international bond markets for the first time.

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