Is Emerging Market Debt Safe? The $8.9 Trillion Question

In 2025, emerging market (EM) debt staged a remarkable comeback, and I, along with many investors, celebrated its strong performance and renewed inflows. Hard currency EM debt, as measured by the JPM EMBI Global Diversified Index, saw impressive returns of 14.3% in USD terms, with high-yield sovereigns particularly strong at 17.0%. Even countries with lower ratings, such as Venezuela and Lebanon, delivered significant gains amidst political and geopolitical shifts. Investment-grade sovereigns also returned a respectable 10.0%. Local currency debt, specifically the JP Morgan GBI-EM Global Diversified Index, performed even better, outperforming with a robust 19.3% USD return, bolstered by positive foreign exchange movements and real yields. This positive momentum, fueled by a weakening US dollar, declining inflation across many EM economies, and proactive central bank rate cuts, has painted a picture of a resilient and attractive asset class for 2025 and an attractive outlook for 2026.

Yet, I believe this seemingly bright outlook masks a critical and underreported vulnerability: a silent debt bomb ticking within specific emerging market and developing economies (EMDEs) that threatens to trigger localized banking crises and broader financial instability. While the overall EM narrative appears favorable, my closer look reveals that external debt burdens in low- and middle-income countries reached a record US$8.9 trillion in 2024, an increase of only 1.1% from 2023, but with interest payments hitting an all-time high of US$415 billion. This strains fiscal space and significantly increases the risk of sovereign defaults in vulnerable nations. What I discovered is that between 2022 and 2024, LMICs experienced an estimated US$741 billion in net financial outflows, marking the largest negative transfer in over five decades of international debt statistics.

The Two-Speed EM Debt Market

The apparent contradiction I've observed stems from a two-speed emerging market debt landscape. On one hand, major emerging economies with robust fundamentals and credible policy frameworks have indeed benefited from a more benign global environment in 2025 and early 2026. Countries like Brazil, Mexico, India, and Indonesia, for instance, have seen improving credit ratings, contained inflation allowing for rate cuts, and increased investor interest seeking diversification beyond developed markets. In fact, 15 of the 19 countries in the JPM GBI-EM Global Diversified Index posted total returns in US dollar terms greater than 10% for 2025. My research indicates that EM central banks, facing domestic fiscal dynamics and currency headwinds, embarked on a policy easing path even as the US Federal Reserve managed its own rate decisions.

On the other hand, a significant portion of EMDEs, particularly frontier markets and lower-rated countries, are grappling with severe debt distress. The cost of borrowing for these nations, especially for USD-denominated bonds, surged from around 4% in 2020 to over 6% in 2024, exceeding 8% for non-investment grade countries. Moody's highlighted in November 2024 that liquidity risk remains high for frontier markets with limited buffers, warning of potential new debt repayment defaults in 2025. The IMF also noted elevated debt vulnerabilities and financing needs in EMDEs as of February 2025. Approximately half of all rated EMDEs in 2024 were categorized as high-risk, with ten already in very high-risk or default status. I've found that twenty-two low-income countries in Sub-Saharan Africa, including Ghana, Zambia, and Ethiopia, are currently in or at high risk of debt distress. Despite some positive signs, such as sovereign bond spreads in 90% of frontier markets being lower in January 2026 than a year prior, the underlying vulnerabilities persist.

The Sovereign-Bank Nexus: A Hidden Contagion Risk

The most insidious threat, which I believe is often overlooked, lies in the deepening sovereign-bank nexus. This connection means that domestic banks in many EMDEs hold substantial portions of their own government's debt. When a sovereign faces debt distress, the value of these government bonds held by local banks plummets. This immediately weakens the banks' balance sheets, leading to a potential "doom loop." As I understand it, a struggling government might be forced to cut spending or even default, which further erodes investor confidence in its domestic banks. In turn, these banks, facing capital shortfalls, become less willing or able to lend to businesses and individuals, creating a credit crunch that stifles economic growth. This can lead to a vicious cycle where a sovereign's fiscal problems trigger a banking crisis, which then exacerbates the sovereign's ability to recover, as I’ve seen in historical examples from countries like Argentina and Lebanon. In early 2026, Argentina’s USD-denominated sovereigns were impacted by investor focus on liquidity risk, with large obligations to the IMF met via emergency support rather than reserves, keeping rollover concerns elevated.

The Shifting Landscape of Creditors and Restructuring Impasses

A new angle I've explored is the evolving creditor landscape, which significantly complicates debt resolution. Historically, debt restructuring involved a relatively coordinated group of Paris Club official creditors. However, I've observed a substantial shift, with the rise of non-Paris Club bilateral creditors, most notably China, and a growing share of private creditors. In 2025, developing countries were expected to pay a record $35 billion in debt repayments to China, with $22 billion coming from the 75 poorest and most vulnerable countries. This marks China’s transition from a net provider of finance to the world's largest single destination for developing country debt service payments.

This diversification of creditors means that reaching consensus on debt restructuring has become incredibly difficult. China, while participating in initiatives like the G20 Common Framework for Debt Treatments, has faced criticism for its sluggishness or perceived obstruction, often prioritizing its own economic problems and seeking to collect its credit. The Common Framework, designed to address deeper debt sustainability issues for the world's poorest countries, has been slow and limited, with only a few countries like Ghana and Zambia successfully employing it to restructure their sovereign debts. This lack of a unified, swift, and transparent mechanism for debt resolution leaves many vulnerable EMDEs in prolonged distress, unable to access new financing or invest in crucial development.

Climate Change: A Compounding Debt Multiplier

Another critical connection I’ve made is the increasingly undeniable link between climate change and debt vulnerability. My research indicates that climate change is not just an environmental issue but a significant economic and financial risk, particularly for EMDEs. Countries highly vulnerable to climate change, often those least responsible for global emissions, face a "triple whammy": the economic damages of climate change, the high fiscal costs of climate adaptation, and higher borrowing costs. I found that climate vulnerability can increase the cost of debt by an average of 1.17 percentage points for a subgroup of 25 developing countries with higher exposure, all members of the V20 climate vulnerable forum. This means that 40 members of the V20 paid an estimated USD 62 billion in additional interest from 2007 to 2016 due to their climate vulnerability, a figure projected to increase to US$168 billion over the next decade.

When climate-related disasters strike – be it floods, droughts, or extreme storms – these countries often have no option but to borrow more for recovery and reconstruction. This exacerbates their existing debt burdens, creating a vicious cycle where greater climate vulnerability raises the cost of debt and diminishes the fiscal space for investment in climate resilience. Moody's analysis in October 2025 revealed that countries most in need of climate adaptation investment are generally least able to afford it, with a median debt-to-GDP ratio of 63% for those with high or very high credit exposure to physical climate risks, compared to 48% for those with lower exposure.

What This Means For Investors, Entrepreneurs, and Professionals

For investors, I believe the two-speed nature of EM debt demands a highly nuanced approach. It's no longer sufficient to treat EM debt as a monolithic asset class. My findings suggest that strong, investment-grade EM economies like Brazil, Mexico, and Indonesia may continue to offer attractive opportunities, especially in local currency debt, which delivered 19.3% returns in 2025. However, I advise extreme caution and thorough due diligence for frontier markets and lower-rated EMDEs, where default risks remain elevated. Diversification, careful analysis of credit ratings, and understanding currency risk are more critical than ever. In 2026, I expect opportunities in higher-yielding EM local debt, provided foreign exchange volatility can be managed.

For entrepreneurs looking to expand into emerging markets, I recommend a strategic focus on countries with robust economic fundamentals and stable debt profiles. Access to credit can be severely constrained in debt-distressed economies, and currency volatility can erode profits. Conversely, resilient EM economies offer growing consumer bases and improving infrastructure, presenting fertile ground for new ventures. For instance, China invested $53 billion in Brazil alone in 2025, and $50 billion in other Latin American countries since 2020, supporting trade corridors and commodity supply relationships.

For professionals in economics, finance, and policymaking, I see an urgent need for innovative solutions to global debt challenges. This includes pushing for greater transparency in lending from all creditors, especially China, and strengthening multilateral debt restructuring frameworks beyond the G20 Common Framework. I believe that proactive debt management, early warning systems for vulnerable economies, and robust financial sector oversight are paramount to preventing localized crises from escalating into broader systemic risks. Addressing the climate-debt nexus also requires integrating climate resilience into financial planning and exploring new financing mechanisms for adaptation in vulnerable countries.

Bottom Line

While 2025 brought a welcome surge in emerging market debt performance, I firmly believe that this masks a deepening crisis in many vulnerable EMDEs, driven by high interest payments, complex creditor dynamics, and the compounding impact of climate change. The market is clearly bifurcated, and I see that a selective and highly discerning approach is essential for navigating the opportunities and significant risks within this crucial asset class.