The impact of high interest rates and refinancing cliffs on developing countries’ debt and fiscal sustainability.

As governments around the developed world continue to pursue interest rates “higher for longer,” through 2025 and beyond, this has sent shockwaves throughout the global financial system. With OECD sovereign debt climbing to a staggering $61 Trillion+, and as huge interest expenditures mount up, foreign investors scramble to take advantage of higher-yielding government debt in the developed world. As a result, a “sovereign debt yield spiral” can dangerously spiral out of control for countries in the developing world.

This article will focus on how a sovereign yield spiral works, and what emerging market (EM) and developing countries (DC) can do about it. We will also have a closer look at the “hard currency” dilemma these countries face, and examine how EM central banks manage to navigate the challenges of higher sovereign yields.

The Nature of a Sovereign Yield Spiral

When a country’s sovereign debt burden creates a self-reinforcing spiral of increasing yields, this can severely stress a country’s fiscal and monetary policy, adversely impacting its currency and balance of payments. Let’s have a closer look at the economic processes that take place during such a spiral.

Emerging market governments that previously borrowed heavily at near-zero interest rates through 2019 and 2020 suddenly face large “refinancing cliffs” at the end of these short- and intermediate-term bonds. As a result, these governments must issue new bonds at these much higher rates, greatly straining their budgets. This, in turn, results in additional pressure on bond yields as more and more of these higher-yielding sovereign bonds are issued, creating a self-reinforcing spiral.

The combination of higher interest rates and widening yield spreads causes the government’s primary deficit to rapidly increase, forcing it to issue even more debt in order to finance this deficit. This creates an additional upward pressure on sovereign yields through a “bid-ask” spread.

As local investors seek to protect themselves from the risks of a depreciating domestic currency, investors seek to offload their local currency-denominated bonds to foreign buyers. However, such demand from foreign investors comes at a price – a much-larger compensation for currency “term risk.” Additionally, a weaker domestic currency reduces import availability, increasing the risk of stagflation in the EM country, which further pressures domestic interest rates to rise.

It is important to note that countries such as Brazil and Mexico have developed well-formatted local currency government debt markets over the past 20 years. As a consequence, they can somewhat mitigate the effects of the yield spiral. However, most developing countries and emerging markets purchase the majority of their government debt in hard currencies such as the US Dollar or Euro, and thus are subject to greater yield risk and currency risk. These sovereign bonds may come at a lower yields as a result, but such “original sin” of the EM countries around the globe can lead to currency crisis if the domestic interest rates must be raised.

In addition to this, local EM banks’ ability to finance the growing volumes of government bonds is hampered by the rapid drying up of global liquidity as foreign investors seek to invest in higher-yielding government bonds. Noteworthy, as many EM countries were net bond issuers during this period, corporate borrowers were “crowded out”

The Impact Of A Yield Spiral On The Economy

Since sovereign yields represent the broad risk-free benchmark within a country’s private bond markets, a rapid increase in them will inevitably translate into higher borrowing rates for corporations as well.

The combination of corporate bond defaults spilling over from the EM crisis, an unprecedented demand for government bonds in the developed world, as well as a large “flight to quality” as inflation fears mount throughout the world, resulted in many EM debt issuers experiencing much wider credit spreads. As a consequence, the EM sovereign issuers found themselves unable to borrow money from international credit markets (such as by issuing Eurobonds).

Breaking A Sovereign Yield Spiral

Sovereign issuers have several tools at their disposal to attempt to break a sovereign debt yield spiral. Let’s explore each of these options.

Implementing fiscal austerity – a decrease in the level of fiscal spending or increase in revenue, resulting in a smaller budget deficit. While this is often seen as unfiscally responsible, such an option helps to restore confidence in the EM issuing country among foreign investors. Fiscal austerity will generally have an adverse effect on the EM’s sovereign spreads, thus reducing government borrowing costs through a smaller yield spread. Restructuring the national debt by issuing more bills and shorter-duration bonds to lower refinancing costs in the short-term, while also reducing “yield curve risk” during periods of higher sovereign yields. Additionally, central banks might choose to focus on raising money through their domestic treasury bill markets, rather than seeking to issue longer-duration bonds.

Developing new institutional investors within the EM country which will be willing to take a longer-duration position in local currency government bonds, in order to smooth out the “interest rate shock” of the yield spiral. Such institutional investors could include domestic pension and insurance companies.

Central banks might also take advantage of existing facilities, by applying for precautionary standby loans, to smooth out the adverse impact of the yield spiral on the EM country’s foreign exchange reserves, as well as boosting the lender’s confidence in the EM sovereign issuer.

Works Cited

  • "Sovereign borrowing outlook: Global Debt Report 2026," OECD Publishing (March 2026).
  • "Emerging Market Debt Commentary: Q1 2026," State Street Global Advisors (April 2026).
  • "Emerging market surge lifts global debt total to record above US$365 trillion," The Standard (September 2026).
  • "Emerging market debt: Enduring strength outlook holds," State Street Investment Management (June 2026).