How vulnerable are emerging markets?
Spreads on emerging market (EM) bond yields have widened to levels not seen since the global financial crisis as concerns grow about the size of the economic downturn and how prepared some emerging economies are for the impending health crisis. Adding to the worries about the vulnerability in emerging economies has been the ability to finance the rising level of government and private market debt as currencies fall and capital outflows accelerate. However, not all emerging markets are exhibiting the same external funding pressures while others have perhaps past the worse of the viral spread.
The largest collapse in global growth since the Great Depression, an oil price that is the lowest in 17 years and sharp depreciation in many EM currencies have raised market concerns about the ability of EM governments to refinance rising debt levels. This is not an unusual occurrence as generally, the credit risk in emerging markets rises at the end of the cycle. The surge in demand for the U.S. dollar globally makes rolling over USD-denominated debt more difficult, or more costly.
EM sovereign spreads rose by 268bps from their tightest this year to 543bps as investors moved to price in a rising default risk. A similar repricing occurred in EM corporate bond spreads which have widened to 501bps. While as dramatic as the moves have been, they do not compare to the shift seen in either the global financial crisis or the Asian financial crisis of the late 1990s.
So what is different this time around? EM governments would normally respond with currency intervention or rate hikes by their central banks to defend currencies and stem capital outflows. The slashing of cash rates in the developed world does ease the pressure on EM central banks to cut rates, but the pursuit of pro-growth polices and fiscal spending to support healthcare, businesses’ survival and the job market deviates from the traditional playbook. Furthermore, the ‘willingness to pay’ offshore creditors may be lower as the focus of spending shifts to ensuring a social safety net is in place.
To assess the risks, investors will need to differentiate economies based on multiple criteria. These include the size of their current account deficit, short-term financing needs, reserve balances, currency depreciation, commodity exporter versus importer. For example countries reliant on oil exports or tourism may see current account positions deteriorate given the collapse in global demand. Exhibit 1 shows the spread of countries based on current account positions, currency depreciation versus the U.S. dollar in the last 12 months and the adequacy of reserves to meet short-term funding requirements. It is clear that each country’s position on the chart can vary greatly based on these metrics, but broadly a better current account position and larger reserves has resulted in less currency pressure.
EXHIBIT 1: CURRENT ACCOUNT POSITIONS, CURRENCY MOVEMENTS AND RESERVE ADEQUACY
Source: FactSet, International Monetary Fund, J.P. Morgan Asset Management.
*Adequate reserves are stocks of a country’s foreign exchange reserves that can cover 3 months of imports (the amount of times available reserves can cover 3months’ worth of imports) and cover short-term debt due in the next year (the amount of times available reserves can pay off debt maturing in the next 12 months and any payments on longer-term debt due in the next 12 months). The larger the bubble, the larger the amount of reserve coverage.
Guide to the Markets –Asia. Data reflect most recently available as of 31/03/20.
Investment implications
The need to differentiate between emerging markets has never been strong as the usual end of cycle concerns around debt and refinancing arise.
Sovereign credit spreads have widened significantly indicating the rising risks, but are nowhere near prior crisis levels despite the economic shock to be far greater than during the global financial crisis. This should not be viewed as an underestimation of the risk given the unusual nature of the shock, the sharp reversal in capital flows and the ability for emerging economies to maintain larger current account deficits. A growing number of countries are looking towards organizations such as the International Monetary Fund (IMF) or World Bank for assistance. The IMF has the ability to quickly allocate funds to countries in need, but can often come with restrictions and is unlikely to want to add to any unsustainable debt levels.
The higher yield on offer in emerging markets will be tempting to income hungry investors but it will be necessary to assess whether the higher yield compensates adequately for the risk, and this will vary on a country-by-country basis.
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