Emerging Markets on the Cusp: Part Two- Emerging Markets and Global Risks

This article is the second  of a series about the challenging global environment facing Emerging Markets/Developing Countries (EM/DCs) living with the legacy of the pandemic and the Ukraine war. In this series, we want to apply the techniques of Country Risk Analysis to assess the changing risk environment, especially as it applies to a potential debt crisis.  

The first article, The Past as Prologue, focuses on the parallels between the first major debt crisis of the 1980s and the situation today. The second one, Emerging Markets and Global Risks, deals with the challenging environment facing the EM/DCs.  The final one, Emerging Markets Debt: Crisis or Resolution?, will analyze the risks of another global debt crisis affecting EM/DCs.

Emerging markets and developing countries face an unprecedented vortex of risks:  a sharp slowdown in the global economy, a sustained tightening of monetary policy in the United States, the European Union and the UK, sharply higher interest rates, a strong dollar and widening bond spreads, soaring commodity and energy prices and a reversal of capital flows.  In addition, the world is facing a deterioration in the geopolitical conditions with the war in Ukraine and rising tensions in the US-China relationship. This challenging global environment comes at a time when EM/DCs are facing a significantly higher debt burden. According to the IMF, 53 countries are the most vulnerable, with their external debt being at near-distress (or in the case of 19 countries, already distressed). 

In this section, we want to analyze further this risk vortex.

Deglobalization:  The pandemic pushed the global economy in a short and deep recession in the second quarter of 2020.  Moreover, the pandemic unveiled a series of underlying weaknesses of the global economic system, in particular the fragility of global supply chains and the fraying of the international economic order—aka globalization. The 1990s and the 2000s were a period of consolidation of the global economic order with the integration of China in the WTO and the liberalization of financial and investment flows.  However, two forces emerged to presage the beginning of a deglobalization.  First, widespread disillusionment with globalization after the 2008 financial crisis, and second, the emerging economic nationalism in both the US and China and the worsening of the relations between the two economic superpowers in the Trump and Xi presidencies.  The pandemic accelerated the trend as it created havoc in both global trade and supply chains.    

The IMF is Worried: The recovery from the pandemic had been steady, but uneven since the trough of 2Q20. Moreover, the combination of the supply chain disruptions, and the super-easy monetary and fiscal policies in the advanced economies led to renewed inflationary pressures after three decades of price moderation that had dominated the world trade and investment environment in the previous three decades.  The IMF’s latest update to its forecast (World Economic Outlook, July 2022) is untypically pessimistic. According to the IMF, the tentative post-pandemic economic recovery of 2021 has been derailed by several shocks: higher-than expected inflation, a tightening of financial conditions, a sharper slowdown in Chinese economic growth and spillovers from the war in Ukraine.  The outlook is “gloomy and uncertain, and the global economy more faces risks that are “overwhelmingly to the downside”.   The UK economy is slinking towards recession, and the soaring energy costs could push the EU to recession by the first quarter of next year. Accordingly, the IMF downgraded its global output growth forecast for 2022 by 0.4%, to 3.2% (from 6.2% in 2021).   The latest US data on inflation indicates a potential ebbing of the inflationary pressures, as well as good news about the strength of the jobs markets.  Nevertheless, these developments are unlikely to change the course of the Fed tightening strategy.

The Fed and the Strong Dollar:  Emerging markets are to a large extent at the mercy of Fed policies.  These policies affect the global economy in general (and the EMS in particular) in two related ways. First, the Fed’s rounds of Quantitative Easing and zero interest rates post 2008 translated in abundant global dollar liquidity.  Second, the level of US interest rates affects the global economy through the value of the dollar. The unprecedented monetary expansion and zero-interest rate policy that followed the financial crisis of 2008—and put in overdrive in response to the pandemic—heralded a “golden age” for emerging markets, allowing governments and corporates alike to access cheap and abundant funds.  However, the Fed policy has suddenly shifted monetary policy from easy to tight in the past few months, raising the Fed funds rate by 150 bp and starting the process of shrinking its $8.5 trillion balance sheet (aka Monetary Tightening).  This shift has had two consequences:  a drying up of liquidity and a strengthening of the US dollar, up by 13% against a basket of currency in the past 12 months.  The combination of higher interest rates and a strong dollar means significantly higher costs of servicing their foreign currency debt by both sovereign and corporate borrowers in EMs.  The Fed’s determination on staying the course has been evident in the tough speech given by the Fed chair Jay Powell at the annual meeting of central bankers at Jackson Hole. This will translate in a continued increase in the benchmark interest rate and an acceleration of the Fed balance sheet—the Fed plans to reduce its holdings of Treasuries and Mortgage Backed Securities by respectively $60 billion and $35 billion a month, staring September 1, 2022.

Energy Markets:  The oil and gas markets exhibited a strong recovery in 2021 and early 2022. Oil prices (WTI) rose to over $100/bbl on the eve the Ukraine war, peaking at over $120/bbl before dropping to less than $90 since mid-July.  Natural gas prices have risen by a factor of 7 since the beginning of the pandemic.  While these soaring energy prices have obviously been a boon for oil producers (Saudi Aramco announcing record profits in the past few quarters), they have been a major burden for energy-importing EM/DCs and a major contributor to international inflation.  In recent weeks, prices of both oil and gas have declined internationally. Nevertheless, past evidence shows that the energy markets remain volatile and that these favorable trends can reverse themselves a short period of time.

While we have seen some evidence of the resilience of the US economy, which could avoid an outright recession, the situation in other markets (the eurozone, the UK and China) point to recessionary conditions by the turn of the year. With these global conditions as background, we will examine the evolution of EM/DCs debt situation in the next post.