The writer is a senior fellow at Harvard Kennedy School
Much has been written on the disconnect between markets and the US real economy. But there’s a much bigger one in emerging markets. Many of them are floating on a tide of liquidity, and investors are seemingly oblivious to what may happen when it goes out.
Three months ago, as the pandemic spread worldwide, EM countries faced crippling capital outflows, plunging commodity prices and cratering currencies. There was $78bn of non-resident capital outflows between late January and late March, according to the Institute of International Finance. By comparison, there was less than $20bn of outflows in the three months after the 2008 global financial crisis exploded.
As investors liquidated assets to buy safe haven US dollars, the real trade weighted dollar strengthened, by nearly 7 per cent so far this year. This made servicing US dollar-denominated debt more expensive for many EMs. Meanwhile oil prices — on which some EM exporters rely for revenues and foreign reserves — collapsed and briefly fell below zero in late April. There have been a record 122 EM debt rating and outlook downgrades since early March, according to Bank of America.
But then, just as EMs looked as if they were heading full speed into a brick wall, spreads on their dollar sovereign bonds narrowed. Yields on developed country bonds fell towards zero. EM governments that could, took advantage, issuing the most dollar bonds in one quarter since 2009. This doesn’t include the poorest developing countries, which have been offered a standstill on official debts by the G20. Elsewhere, EM sovereigns have issued $131bn so far this year, 42 per cent more than in 2019.
It’s hard to fault EM governments for taking advantage of the new environment. Major central banks have unleashed unprecedented amounts of liquidity in response to the coronavirus crisis. This has compressed borrowing costs in all markets, so a hunt for yield has driven investors into EM assets. Emerging market currencies have risen, on average, in the second quarter, led by the Indonesian rupiah, Russian rouble and Colombian peso. As parts of the global economy have reopened, demand for oil has rebounded, with Brent crude prices almost trebling since March.
Economists normally worry when EMs issue more international debt. That is because such bonds are riskier than local debt as they are denominated in overseas currencies, which exposes the borrower to currency risk. They are often governed by foreign law, so if the EM issuer gets into trouble it cannot simply legislate a change in terms. International debt burdens also can’t be alleviated via domestic inflation.
In this case, however, most of the new EM debt was issued by investment grade sovereigns. They also issued bonds with longer maturities than in the first quarter, and only slightly higher coupons. High yield issuers have been more active since June. But, according to the IIF, their bonds have been issued at lower yields than in recent years and at equivalent maturities. All this helps make EM debt loads more sustainable. Markets easily absorbed the issuance.
None of this means an EM debt crisis has been averted, though. The wave of foreign central bank liquidity hasn’t crested, yet. But it might by early next year. The US Federal Reserve has dialled back the amounts it puts into markets, and many of its lending programmes have had relatively little take-up. Meanwhile, Europe and Asia have so far largely contained the outbreak, which has enabled their economies to reopen slowly and eased pressure on their central banks to announce additional measures.
Moreover, reopened economies don’t mean fast-growing economies. The damage done to global demand has been enormous, and so far there’s no vaccine. Many EM countries will suffer as global trade plunges at least 13 per cent this year. EM state-owned enterprises such as airlines and utilities, which account for about 60 per cent of non-financial EM corporate debt, increasingly need bailouts. Oil prices remain a third below where they started the year. Tourism and remittances, on which many EM countries rely for revenues, have been devastated. The latter is forecast to fall by $100bn this year.
Given such challenges, the issue is how EMs will continue to be able to service their debts. Central bank liquidity papered over the first sudden stop in EM capital flows. But that may not be enough, or last long enough, for subsequent stops. EMs remain in the eye of the storm, and both investors and the IMF need to be ready for the inevitable next wave of volatility.
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