The turning credit cycle and growing macroeconomic headwinds are creating a complex set of challenges for emerging markets (EMs). A toxic combination of front-loaded tightening by the US Federal Reserve, high food and energy prices and growth scarring from the pandemic are combining simultaneously. Although EMs are disproportionally impacted by this very challenging backdrop, we do not expect the asset class as a whole to face a debt crisis.

There are several reasons to be more constructive towards emerging markets over the course of the year. Soft commodity spot prices including wheat, corn and soybean have declined to pre-Russia-Ukraine military conflict levels, which, alongside lower oil prices should help to slow inflation in emerging markets in the second half of the year. Moreover, as market expectations of Fed tightening began around three months prior to the first hike in March 2022, and now almost fully incorporate the total amount of tightening that we expect by the end of 2022, the impact of the remaining Fed rate hikes on emerging market financial conditions is likely to be less severe than in the first half of 2022.

download

Portfolio outflows from EMs have also been less broad-based than during past crises. Larger, investment-grade EMs have remained resilient to capital outflows so far, while currencies and sovereign bond spreads have weakened only modestly. By contrast, lower-rated EMs have experienced a more negative impact, with greater currency depreciations and much larger increases in sovereign spreads. We expect these dynamics to persist through the rest of 2022.

download

Proactive monetary policy responses and less reliance on external funding have contributed to this resilience. Many major EM central banks have been proactive in raising rates and are well ahead of the Fed tightening cycle, helping to mitigate outflows and the impact on exchange rates. In addition, emerging markets have also developed their domestic capital markets over the last decade, which provides a degree of resiliency to their funding. With real interest rates still negative in some EMs, there is some space for further policy tightening if required.

download

download

The most acute risks from the current environment will be via external financing for frontier markets and other lower-rated sovereigns. Investment-grade EM credit profiles can largely withstand a modest increase in social and political risks derived from higher food and energy prices, even when it will pressure government finances. For lower-rated sovereigns, however, current market conditions also make liquidity risks more acute, and sovereigns with large upcoming international debt maturities or facing import payments that have become more expensive, are likely to face reserve drawdowns and will be at elevated risk of balance-of-payments crises.

To triage the sovereigns most at risk, we look at those that have an external vulnerability indicator reading over 100%, and sovereign spreads that are over 750 bps. This captures the sovereigns that have the largest external debt obligations falling due and the least capacity to refinance in current market conditions.

download

El Salvador, Tunisia, Turkiye and Pakistan stand out as highly exposed to tighter global funding conditions, while other sovereigns that have already defaulted on external debt like Sri Lanka and Zambia, or countries already in the Caa3 or lower category including Suriname, Argentina and Ukraine are also in the highest risk group. Ghana's maturities do not peak until 2026, which is why it is not in our higher risk buckets, but fewer financing alternatives are already elevating credit risks.

To see which other sovereigns we highlight as most exposed to the turning credit cycle, please see our full report below, or tune in to episode 29 of our Emerging Markets Decoded Podcast.

Emerging market financial conditions have been tightening since the mid-2021 but this trend accelerated after the outbreak of the Russia-Ukraine crisis which has triggered food and energy shortfalls and exacerbated global inflationary pressures. These inflationary shocks have been felt most acutely in emerging markets, where food and energy comprise a larger share of household consumption compared to developed markets. As a result, some emerging market central banks began their hiking cycles earlier than their developed market counterparts.

In recent months, EM sovereign spreads in some regions have also come under pressure, most notably those in Europe, due to their proximity to the Russia-Ukraine conflict and in Africa, where sovereign credit ratings are lower on average, and sovereigns are more vulnerable to loss of market access as financial conditions tighten. Many African sovereigns still face deep economic scarring from the pandemic, which has led to revenue losses, delays to planned fiscal consolidation and a sharp rise in debt. Moreover, challenging economic conditions will make it difficult for policymakers to improve fiscal positions through a combination of tax increases and spending cuts without aggravating already high social risks.

download

Although the prospect of rate increases by central banks in advanced economies was already contributing to a rise in international borrowing costs, Russia’s invasion of Ukraine (Caa3 negative) in February 2022 has accelerated this trend. Much tighter global financial conditions has already had an impact on future issuance. In fact, only South Africa (Ba2 stable), Angola (B3 stable) and Nigeria (B2 stable) have been able to issue an international bond in 2022, with no issuance since May. Other countries like Kenya, Nigeria and Côte d’Ivoire have decided to postpone planned debt issuance in response to market conditions.

The deterioration of market access will increase financing pressures, as maturities on international bonds issued in the previous decade will increase for a number of African sovereigns over the next few years. Maturities will peak in 2024 for the region overall, with large debt amortizations falling due in Kenya (B2 negative, $2.0 billion), Egypt ($3.3 billion), Morocco (Ba1 negative, $1.1 billion), and Tunisia ($962 million). This upcoming maturity wall will increase financing pressures, particularly for lower-rated sovereigns with a limited track record of repaying international bonds.

download

While market conditions today may mean borrowing is prohibitively expensive, some countries like Kenya still intend to access bond markets later this year. Moreover, there is still time for sovereigns with large maturities in 2024 to refinance these near-term maturities. High inflation and social pressures will make fiscal prudence delivery very challenging, and global financial conditions in the second half of this year will be very telling regarding market access to refinancing.

Colombia will hold a pivotal runoff election on Sunday June 19 amid rising social tensions, not only in Colombia but across Latin America and other emerging markets, as rising inflation erodes household living standards and economic scarring from the pandemic clouds the growth outlook. The outcome may be a useful bellwether to see how these forces will reshape the political landscape for other major emerging market sovereigns.

The two candidates in Colombia’s election – Gustavo Petro, a former mayor of Bogota, and businessman Rodolfo Hernández – have both pledged to make significant changes to the country's economic and political system amid rising social tensions. Petro has proposed policies that could weigh on investor sentiment, including altering the central bank's mandate, imposing import tariffs, and renegotiating the country's free trade agreement with the US. Hernández has stated that his government would be austere and seek to reduce spending by decreasing the size of the government workforce. Both intend to implement policies that accelerate carbon transition, impacting the oil and gas sector. However, either candidate will likely have to moderate their manifesto once elected to secure the support of the legislature.

As the exhibit below shows, Colombia's risk premiums have widened compared with those of similarly rated regional peers since May 2021, at which point large-scale protests contributed to the government withdrawing its initial fiscal reform proposal. While we expect that Colombia’s legislative and judicial checks and balances will prevent the more radical policy changes from being implemented, If the policies of the next administration weigh on investor confidence, this could result in permanently lower investment in the country and hence lower potential GDP growth.

download