A few short months ago, markets were imbued with a sense of optimism as the likelihood of a soft landing appeared to be growing. After prolonged pandemic lockdowns, the Chinese economy was beginning to reopen at a faster-than-expected pace. Developed-market (DM) economies were showing resilience in the face of aggressive action by central banks around the world, whose policy actions started to bear fruit as inflationary dynamics began to cool. In combination, these factors all pointed to a more upbeat global economic growth scenario, one that would also provide support for emerging markets (EM).
But with two tech-focused lenders collapsing in recent months, cracks in the global financial system are now evident and the risk of financial contagion remains a concern. The banking turmoil has increased the probability of a U.S. recession and could hamper global economic growth. Against this backdrop, we feel it necessary to take a closer look at EM debt, assessing whether the asset class might be vulnerable considering these events.
Global central bank policy tightening
Financial markets are still navigating the ripple effects of Russia’s invasion of Ukraine, with heightened volatility brought on by materially tighter funding conditions. The extent of the financial tightening across the developed and emerging world has been unprecedented, with global banks around the world embarking on ambitious tightening cycles.
The U.S. Federal Reserve has raised rates by nearly 500 basis points (bps) over the past 12 months while the European Central Bank has tightened by 350bps since last summer. Central banks from EM countries have generally seen an even greater magnitude of tightening, having begun the process months ahead of those in developed markets.
EM central banks have tightened further and faster than those of DM
Central bank policy rates since 2020
Source: Bloomberg, as of April 21, 2023. EM refers to emerging market. DM refers to developed market.
Notable action in EM central banks include the Banco Central do Brasil in Brazil raising rates by 11.75%, Banco de Mexico in Mexico by 7.25%, the South African Reserve Bank in South Africa by 4.25%, and the Bank of Korea in South Korea by 3.00%. This trailblazing stance from several EM central banks proved to be a powerful tool in restraining capital outflows and supporting the foreign exchange rates against the U.S. dollar. These actions also provide evidence that these markets are willing to take a proactive approach and prioritize a level of fiscal prudence that wasn’t evident in past crises.
But with many developed and emerging sovereigns calling the peak of their tightening cycle, an economic growth slowdown will be challenging to navigate for the most indebted EM issuers as any further support for currency valuations will be limited. A U.S. dollar surge can put pressure on many pockets of the global economy, including EM sovereigns’ ability to service their U.S. dollar-denominated debt, particularly when paired with elevated borrowing costs.
Dollar strength could have varying impacts
Across the EM universe, we see great variability in the degree of financial vulnerability to a surge in the U.S. dollar. To assess which countries might be most at risk, we looked at metrics such as current account balance, the level of foreign exchange reserves, and the overall debt profile subject to material foreign currency debt obligations. We also consider the unique framework that each central bank employs to conduct its monetary policy and satisfy its specific mandate. The data shows an uneven impact among EM countries, with a handful of mostly frontier markets being the most ill-equipped to handle this shift in market conditions.
Debt-to-GDP levels remain reasonable for most EM countries
IMF general government gross debt % of GDP, 2023
Source: International Monetary Fund, Bloomberg, as of March 31, 2023. EM refers to emerging market.
Debt to GDP is a useful measure comparing the size of a country’s debt in context to the size of its economic output, resulting in a measure of a country’s fiscal health and prudence. The higher the ratio, the more challenging it becomes for a country to service its debt, increasing the risk of default. This is especially true during periods of economic stress with elevated borrowing rates.
Studies by the World Bank have shown that higher debt-to-GDP ratios have an adverse effect on economic growth, slowing growth and impeding a country’s ability to repay or refinance, creating a downward spiral. A lower ratio means the country is producing more than it owes, inferring greater financial flexibility.
Japan, a DM and the third-largest economy, has the most noticeable debt-to-GDP ratio in the world. Japan has been navigating challenging economic waters for decades yet has been able to service and refinance its debt at ultra-low interest rates.
In contrast, EM countries that have outsized levels of debt relative to GDP will likely not have the same ability to refinance without the market assessing a premium, translating to materially higher funding rates. With the data showing that most EM countries have debt-to-GDP ratios below 100%, we believe that most of these economies remain on sound financial footing and won’t be subject to this refinancing risk.
Foreign currency reserves can provide a buffer
Moody’s External Vulnerability Indicator (EVI), a metric that measures short- and long-term debt repayments relative to official foreign currency reserves, gives us another insight into the risks across the EM spectrum.
Some countries more vulnerable to tighter financial conditions than others
External Vulnerability Indicator (EVI) ranking
Source: Moody’s Investors Service, April 2023.
On the more vulnerable end of the spectrum, Mozambique, Tunisia, El Salvador, and Pakistan rank among the most distressed EM sovereigns. Türkiye, a country that has enacted unorthodox monetary policies despite its hyperinflation, also shows significant vulnerability. In March, Türkiye’s inflation was softer than market expectations but still printed at a staggering 50.5%.
On the other end of the spectrum, countries such as Peru, Philippines, Thailand, Brazil, and Cambodia seem to be relatively well positioned to handle the financing pressure, with several other countries also having an EVI below 100, indicating that they maintain an adequate level of reserves.
Impact on credit ratings
Credit ratings are another tool that can help us assess which countries might have the ability to withstand tighter global financing conditions. We believe that investment-grade sovereigns are likely to show resilience while the more vulnerable higher yielding (or lower credit quality) sovereigns could experience more pronounced financial stress.
Many EM countries have been affected by elevated borrowing costs and persistently high levels of inflation, resulting in several credit rating actions including a handful of defaults since the beginning of 2022: Sri Lanka (May), Russia (June), Belarus (July), and Ukraine (August).
Downgrades have outnumbered upgrades since the start of 2022
Source: Fitch Ratings, as of March 17, 2023.
We also believe that the current momentum of downgrades relative to upgrades is expected to extend through the rest of this year. However, we feel it’s equally important to highlight that the stress induced by the pandemic and other external factors since 2020 has localized challenges in the frontier EM space.
Conversely, this stress has provided a wake-up call for many EM countries, driving them to prioritize a level of fiscal discipline and flexibility that will allow for them to better withstand future economic shocks. This is reflected in the high level of positive outlook revisions, outnumbering the pace of negative outlook revisions since the beginning of 2022. For this momentum to extend further, global growth dynamics will be of paramount importance.
Outlook revisions have tended to be positive
Source: Fitch Ratings, as of March 17, 2023.
Investment and credit selection are key
Geopolitics will continue to take center stage in any market discussion. The possibility for renewed escalation between China and the United States along with the potential for escalation of the Russia/Ukraine military conflict as it enters its second year could inject further volatility into the markets, even as the global economy is still recovering from the ripple effects emanating from Russia invasion of Ukraine last year.
Social implications are of concern too, with worries over food availability shifting to one of food affordability. Increasing costs paired with heightened energy expenses have translated into a full-blown cost-of-living crisis across both advanced and emerging economies, creating the potential for social unrest and political instability. Although EM might be more prone, these concerns are a global issue as any country can be subject to political pressure as basic needs demand higher levels of income.
Looking ahead, we believe that financial markets will continue to operate against a challenging economic backdrop, heightened uncertainty, and an elevated level of market volatility. Even still, our assessment indicates that many emerging markets are sufficiently equipped to weather what lies ahead.
In this environment, we believe it becomes imperative to take a selective approach, relying on both top-down macro analysis and bottom-up security selection. Integrating ESG within each step of the investment process to fully evaluate holdings allows for a more comprehensive view from both a sovereign and issuer-specific perspective. Being able to identify excess return opportunities while deviating away from assets that are cheap for a reason will be of high importance for EM debt portfolios in the environment ahead.
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