Emerging markets and frontier markets, despite their huge potential, do contain risk. That is particularly noticeable in times of crisis like today. The Institute of International Finance (IIF) reported that investors have already taken $95b USD out of Emerging Market stocks and bonds since late January.
Investors have every reason to be concerned. Most emerging market governments have large budget deficits and unsustainable public debt ratios. Both human and fiscal costs could eventually force distressed emerging markets to default on their debts. Capital Economics notes that 17 emerging market governments now have bond spreads over 1,000bp which is a predictor for defaults historically. It includes countries like Ecuador, Lebanon, Nigeria and Argentina.
Emerging markets and frontier markets are particularly vulnerable when it comes to fiscal threats. Governments are now facing the burden of debt rates that were already problematic before the pandemic. From 2010 to the end of 2019, the total debt of the 30 largest emerging markets grew from $28tn USD to $71tn USD. This compares to a surge of 168% of GDP to 220% of GDP. Those debts were relatively manageable because of attractive interest rates and investment appetite, but that is not the case anymore. The IIF claims that, for example, South Africa's government debt could reach an unsustainable rate of 95% of GDP. Furthermore, most emerging markets need loans to finance the costs of stimulus packages and to support healthcare services. Borrowing costs are already rising and at some point will make debts unsustainable. This will subsequently limit the fiscal flexibility of countries to battle the pandemic.
Local currencies are also heavily affected by the crisis. Investors fled to the relative safe US dollar and left local currencies behind. The Brazilian Real for example, already under pressure before this crisis, lost more than 25% of its value compared to the US Dollar. Other currencies are not doing much better. The Turkish Lira dropped with 14%, the South Korean Won with 5%, the Mexican Peso with 24% and the South African Rand with 32%. The Indonesian Rupiah even sank to a historic low not seen since the 1998 monetary crisis.
The mentioned rates are likely to worsen with emerging market governments forced to spend more while their economies contract.
Good news seemed to come out of a recent OPEC+ meeting. Participants met in a video conference to do something about the historically low oil prices.
Many emerging markets depend on the export of natural resources, including oil. This dependency represents a lack of economic diversification but is also a vulnerability when international trade is down. Particularly oil-producing countries are sensitive to swings in global demand. The oil price collapsed after a price war between Russia and OPEC-leader Saudi Arabia in early March. Both countries decided to produce more oil resulting in an oversupply of the commodity. Although Russia and Saudi Arabia have plenty of reserves and can produce oil cheaply, they completely underestimated the economic impact of the coronavirus. As a result, the oil price dropped to a historic low.
The OPEC+ negotiations were resumed in April. Saudi-Arabia and its OPEC partners agreed with Russia on a deal that allows for daily production cuts upto 10m-11m barrels. Analysts argued this was the absolute minimum and expressed disappointment. This rate does still not compensate for the loss in demand due to the COVID-19 crisis. If the energy nations really want to see a change, they should at least cut 15m barrels a day and possibly even 20m barrels.
A glimmer of hope is the willingness of oil-producing countries to negotiate. Oil prices are still low which might force them to make further cuts. A more considerable source of hope comes from emerging markets who are net importers of energy products, especially in Asia. Giants such as India and China will benefit from low oil prices which support their fiscal policies and currencies. Consumers and businesses will benefit from low prices as well.
Regardless, emerging markets depended on oil production or any other natural resource will likely go through an extended period of revenue loss.
Global incentives to prevent the world economy from collapsing are praiseworthy. The World Bank and IMF, for example, have called for an immediate suspension of debt payments for low-income countries. The IMF also increased the number of countries it is giving emergency assistance packages. The list now includes countries like Ghana, Panama and Pakistan.
High income countries are also assisting emerging markets and frontier markets. Brazil, South Korea and Mexico have been offered swap lines of $60b USD from the US Federal Reserve. This provides them with more dollar liquidity to meet financial needs. France announced its support for helping the poorest markets in this world with Finance Minister Bruno Le Maire saying that the French government will argue for a debt moratorium.
Credit-agencies, however, warn that plans to provide debt relief to those markets could increase the risk of default. Fitch claims that restructuring payment obligations to private sector creditors is a mistake because it is a distressed debt exchange that can still lead up to a default. Relief should therefore only apply to debt by official creditors, according to both Fitch and Moody’s.
This concern has been picked up by other countries. The Group of G20 agreed last week that low income countries can now suspend debt payments to other governments. The measure would free up $14b USD, according to the World Bank.
Investors are justified to be concerned about the economic outlook for emerging markets and frontier markets. There are many variables at play, even when the worst of the pandemic is over. Regardless, no one knows for how long this crisis will continue. While China seems to be slowly restarting, some experts think that Latin America is not even close to its peak. The economic impact of the coronavirus might go beyond 2020. Many social restriction measures can’t be removed until there is a vaccine widely available which can take up to a year and a half.
Investors have taken dozens of billions out of Emerging Market Funds. The outflows are especially damaging for emerging markets who depend on foreign capital. This adds up to the loss of foreign capital due to the impact on tourism, remittances from migrant workers, and oil prices. Furthermore, much of the foreign direct investment was already hampered as a result of the US-China trade war. This negatively impacts the outlook for emerging markets even further.
Regardless, concern among investors might also be a bit exaggerated. Default risks are likely lower than feared because of massive international incentives to prevent countries from falling over. The OPEC+ agreement, central bank interventions, and incentives by multilateral organizations might not have been enough, but they show a hopeful willingness to prevent the situation from escalating. Europe, the United States and China are also separately looking for ways to help debt-ridden countries with access to liquidity and debt forgiveness. Furthermore, in some countries like China and South Korea the worst seems to be over. Some resumption of economic activity in both emerging markets and developed countries will lead to a better understanding of the actual damage. It might take a long time before emerging markets will have picked up their game again but there are reasons to believe there will be considerable improvements in the short to mid-term.
Tjeerd S. Ritmeester
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