In this episode of Moody's Talks – Emerging Markets Decoded, Scott Phillips of the Global Emerging Markets team joins host Shirin Mohammadi to discuss a recent turn of events for emerging market credit conditions, including some easing in financial conditions, with inflation, yields and spreads all lower than at the end of 2022, despite continued volatility. They explore what recent events mean for debt issuers in emerging and frontier economies and reveal which sovereigns are still at risk of default.

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.

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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.

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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.

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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.

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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.

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.

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Net-zero carbon commitments are no longer limited to advanced economies: most of the largest EM countries including China, India, Brazil, Indonesia and Saudi Arabia have announced a target. However, efforts to meet these commitments will increase carbon transition risk for the most exposed issuers in these regions, especially those in hard-to-abate sectors. While emerging markets will reap myriad health benefits from the transition to a low-carbon economy, including curbs in pollution-related mortality rates and health issues, adjusting to a low-carbon economy will require balancing economic considerations against decarbonization efforts.

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Our analysis shows that most of the investable universe in EMs is from carbon-intensive sectors: around half of the Eurobonds issued last year by emerging market issuers were from carbon-intensive sectors such as oil and gas and utilities. Consequently, a sharp increase in investments is needed to finance a transition to a low-carbon economy: more than $1 trillion in annual clean and energy efficiency investments will be needed in emerging market economies under the IEA’s Net Zero Emissions by 2050 scenario. Moreover, raising this level of capital investment from concessional and market based financing sources will be challenging, and the commitments made to date from multilateral development banks fall well short of most emerging markets’ climate-investment requirements.

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The level of differentiation between companies in emerging markets and advanced economies is contingent on a sector’s inherent exposure, business model and policy mix. Emerging market companies in hard-to-abate sectors like oil and gas, steel and airlines are more exposed to transition risks than those in sectors with scalable technologies, such as electric utilities and auto manufacturers.

In some of these sectors, emerging markets have some advantages over their advanced economy counterparts. For example, in the oil and gas sector, emerging market oil refiners are better positioned for carbon transition because middle distillates and petrochemicals are less exposed to carbon transition risk than light distillates like gasoline. However, in other sectors like steel production, less energy efficient furnaces place the Chinese and Indian steelmakers in a more vulnerable position to carbon transition than their peers with a greater share of efficient electric arc furnaces (EAF) in the United States. That said, in the short-term, the surge in scrap metal prices arising from the Russia-Ukraine crisis puts steelmakers with higher EAF capacity at disadvantage.

Financial conditions in Russia have deteriorated severely in the wake of the invasion of Ukraine and the subsequent imposition of far reaching sanctions. While the deterioration has been sharp enough to move our aggregate emerging market financial conditions indicator to more than one standard deviation below its long-term average, this has been almost entirely driven by Russia, with the remaining eight major emerging markets covered in our EM financial conditions monitor all reporting more positive financial conditions than the aggregate indicator.

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Contagion through financial market, including emerging market exchange rates and sovereign spreads, and macroeconomic channels to the rest of the EM universe has been relatively contained so far. EM exchange rates have been particularly resilient, with the Brazilian real, Mexican peso and South African rand strengthening against the dollar over March, supported by hawkish domestic monetary policy stances.

However, additional inflationary pressures from the Ukraine crisis will drive tighter monetary policy across major emerging market central banks. The surge in global oil, metals and food prices following Russia’s inflation of Ukraine will create a further inflationary shock which emerging markets will be more exposed to than advanced economies. While growth in headline inflation slowed or paused for many major EMs in February, consumer prices will rise again over the coming months in many emerging markets. Our baseline scenario assumes oil prices will average over $120/bbl in Q2.

The decision-making process of emerging market central banks will be complicated by the fact that the economic recovery remains fragile in some of these countries. Projected real GDP growth for 2022 is barely in line with, or in some cases below, the long-term average in Mexico and Brazil. The recent rise in oil prices, if sustained, will also be negative for growth and inflation, particularly in net oil-importing sovereigns like India, Turkey and South Africa.

Moreover, not all emerging markets have proved immune, and particularly those with weaker credit ratings have seen market access become more challenging. For example, as of 7 March, Egypt's risk premium in global capital markets peaked at 1,040 basis points (bp) from 705 bp at the start of February, reflecting the country's exposure to global capital markets disruptions following Russia’s invasion of Ukraine. Risk premiums at these levels indicates interrupted access to external markets at affordable terms. If interrupted market access persists, liquidity risks will increase for Egypt.

Visit Moody’s dedicated website for latest credit insights on the Russia-Ukraine crisis

Russia’s escalation of military activities in Ukraine represent a significant further elevation of geopolitical risks. The invasion has been met with a wave of severe sanctions from Western countries, including the sanctioning of the Central Bank of the Russian Federation (CBR) and some large financial institution. The scope and severity of the sanctions announced to date have gone beyond our initial expectations and will have material credit implications. Severe and coordinated sanctions imposed on Russia together with its retaliatory response in recent days have materially impaired its ability to execute cross-border transactions. In addition, we expect that the capital controls imposed by the Central Bank of Russia (CBR) will restrict cross border payments including for debt service – a view supported by a reported statement from the National Settlement Depository (NSD) that coupon payments on OFZ government bonds due on Wednesday 2 March have only been paid to local holders of the papers, citing the CBR order prohibiting payments to non-residents – a key driver behind our decision to downgrade the sovereign rating to Ca with a negative outlook.

Russia’s financial sector is also heavily exposed to the fallout from the invasion, following the announcement by the United States, European Union and others of their intention to restrict Russia's largest banks from using the SWIFT payment messaging system, complicating funds transfer and cross border payments. Furthermore, sanctions against the Russian central bank will hamper the use of foreign reserves to defend the ruble. The sanctioning of state-owned Russian banks aims to effectively block the institutions from participating in the global financial system and make it exceptionally difficult to engage in international transactions, particularly in US dollars. Russian banks may also struggle to find counterparties to help facilitate cross-border transactions given the compliance risk of dealing with a sanctioned entity.

While the impact of the military conflict will be felt most acutely by both Ukraine and Russia, through both the human toll and economic upheaval, there will nonetheless be spillover effects on the rest of the world through three major channels: commodity price shocks at a time when inflation is already high and supply constraints remain a challenge globally; financial repercussions from the sweeping new sanctions against Russia and financial market volatility; and potential additional security challenges.

Commodity prices will have a particularly acute effect for emerging markets given the higher share of raw goods in their inflation baskets. Since the invasion, oil prices have soared above $100 per barrel, which will exacerbate the high inflation environment if they remain at that level. Prices for agricultural commodities such as wheat, sunflower oil and corn have also risen as a result of supply risks. Together, Russia and Ukraine provide roughly 14% of the world’s wheat supply and 25% of global wheat exports, although the impact on food supply is mitigated to some extent because these events are unfolding during the winter and not during harvest season.

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Tensions between Russia and Ukraine have been steadily increasing as Russian troops and equipment have been spotted amassing around the north, east and southern borders of Ukraine, raising fears that a further Russian invasion is imminent.

While a number of Western countries including the US and the UK have provided support in the form of military aid, a military intervention alongside Ukraine remains unlikely. Instead, Western countries are preparing a package of new sanctions to be enacted in the event of any further Russian military incursion into Ukraine.

Any Russian military incursion into Ukraine, whether short-lived and limited or prolonged and extensive, would result in new sanctions being imposed on the Russian sovereign. While the sectors targeted and the degree of coordination between Western countries has yet to be finalized, the US has progressed further than other Western countries in outlining potential new sanctions on Russia. Some of the most notable sanctions contained in the US’ proposed bill include (1) extension of sovereign debt sanctions to the secondary market; (2) restrictions on Russian banks' access to international payment systems; and (3) the addition of Russian financial institutions to the Specially Designated Nationals and Blocked Persons (SDN) List. We explore the impact of each of these potential measures on Russia in our latest FAQ.

Even without the imposition of sanctions, rising tensions have adversely affected Russian banks. Russian securities have already taken a significant hit as fears over a military conflict have risen, with the IMOEX index trading around 13% lower toward the end of January compared to the start of the year, while treasury yields on Russian bonds were around 140 basis points higher than a month earlier. While these should remain paper losses unless sold, the devaluation of the securities portfolios will still weaken capital ratios. Russian banks with a high volume of securities in relation to their capital, including systemically important banks including Russian Agricultural Bank (Ba1 stable), Sovcombank (Ba1 stable), Credit Bank of Moscow (Ba3 stable) and Tinkoff Bank (Ba2 stable), will be most exposed to this market volatility.

European sovereigns also stand to be affected by an outbreak of hostilities as any sanctions they impose would expose them to the risk of retaliatory countermeasures from Russia. Given Europe's reliance on Russian hydrocarbon imports, energy supply is likely to be the dominant channel through which the regions' sovereigns would be impacted by such a scenario.

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Russian imports account for 46% of the Europe's solid fuels (such as coal), over a third of its natural gas and over a quarter of its crude oil. As a result, any decision by the Russian authorities to lower energy supplies to gain political leverage or in response to EU sanctions would have major implications for EU energy supplies. Moreover, Russian gas cannot be easily and quickly substituted, not least because the EU's total liquefied natural gas (LNG) terminal capacity would at best only cover about one quarter of total demand.

Sovereigns that share a border with Russia, such as Estonia and Latvia, are also vulnerable to trade disruption and security risks, especially cyberattacks. Rather than outright armed conflict, security risks are much more likely to take the form of cyberattacks on key digital infrastructure, or other efforts to disrupt the functioning of society and government institutions, for example through disinformation campaigns, attempts to stoke civil unrest or political interference.

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Among the Commonwealth of Independent States (CIS) the risks from a Russian invasion of Ukraine are relatively low and are mainly via the adverse impact on remittances, trade and investor confidence that would arise from new Western sanctions on the Russian economy. Many CIS countries, most notably Moldova, are largely reliant on Russia for oil and gas, although the risk of disruption to supplies is low. Significant new sanctions targeting the cross-border operations of large Russian banks could have financial consequences for regional banking systems. That said, Russian banks generally have a very limited presence in CIS banking systems, with their subsidiaries making up a notable part of the domestic banking system only in Belarus and Kazakhstan.

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The recent rise in US treasury and bund yields reflects markets' expectations that major central banks are poised to remove monetary and liquidity support to their economies, given rising inflation and growing confidence that macroeconomic conditions are normalizing.

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For emerging market countries, external financial conditions are bound to tighten over the coming two years regardless of the stage at which their own monetary policy cycles are, limiting their maneuvering room. Several major emerging market central banks are months ahead in the rate hike cycle because of domestic inflation above central banks’ targets and have thus faced tight financial conditions since last summer.

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See Emerging Markets - Global: Financial Conditions Monitor: January 2022 (Slides)

For EMs that face significant domestic inflationary pressures, the risk of additional pass-through pressures from further currency depreciations after markets incorporate higher US interest rates will be an important consideration in setting monetary policy. Overall, when confronted with a choice between inflation and growth, emerging market central banks that have a degree of autonomy over monetary policy will lean on the side of curbing inflation to avoid the politically unpopular outcome of a steady erosion of household purchasing power and low real returns to savings.

Countries recovering at a relatively faster pace will be better positioned to withstand monetary policy tightening. Countries with large domestically funded financial markets, including India, Malaysia and Brazil are less susceptible to sustained currency depreciations driven by capital outflows. Finally, with the Fed likely to reduce policy support earlier and more rapidly than the ECB, countries closer to the US’ economic and financial influence are more susceptible, in contrast to those more exposed to the euro area.

The emergence of the Omicron coronavirus variant poses new risks to the global economic growth and inflation outlook, as concerns mount about the variant's health risks and several countries have imposed new travel restrictions in recent days. However, the risks to emerging markets are particularly acute: should the new variant lead to another rising wave of COVID-19 infections, the hardest-hit economies will be those with lower vaccination rates, higher dependence on tourism and lower capacity to offer additional fiscal and monetary policy support to offset the growth impact of the resurgence in infections.

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Macroeconomics – Global

Vaccination rates vary across emerging markets but remain on average lower than developed markets

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Amongst emerging market countries, the economic impact from the outbreak will not be homogenous, and will depend on a mix of government restrictions, public comfort with social interactions, and the capacity of governments and central banks to provide additional policy support to the private sector, if needed.

Even prior to the outbreak of the latest coronavirus variant, emerging markets were already coping with more rapid than anticipated increases in inflation and persistent supply chains disruptions. High food and energy prices, which account for a large share of emerging market’s disposable income, has led to rapid increases in headline inflation in major emerging markets including Turkey, Brazil, Mexico and Russia, increasing the risk of government mandated price controls, which could weaken corporate profitability.

The latest outbreak could also have implications for the easing of supply chain bottlenecks. Over recent months, high-frequency alternative trade indexes, which reflected base effects earlier in the year, suggested an ongoing but uneven recovery across emerging markets (EMs).

China Evergrande Group averted default on the final day of its 30 day grace period on November 10. Nonetheless, the financial troubles facing one of China’s largest property developers and the toll it is taking on the real estate sector will have repercussions on China’s local and regional governments (RLGs) as well.

Chinese RLGs are likely to suffer a drop in land sales revenue because of the growing challenges facing the real estate sector, while debt levels are likely to rise to maintain infrastructure investment in response to slowing real estate activity. Land sales are a significant revenue stream from China’s RLGs, accounting for roughly one-third in total revenue. Consequently, highly indebted provinces with higher land-sales reliance, such as Guizhou, will face fiscal pressure in a property market slowdown.

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Aside from the revenue impact, the property slowdown is also likely to trigger a rise in RLG bond issuance in 2022, as falling land sales prompt the authorities to resort to debt-funded infrastructure investment to drive regional economic growth.

Despite the impact on RLGs, we expect that Evergrande credit distress will have limited direct impact on the sovereign, although the developer’s troubles are likely to trim economic growth, given the property sector’s large contribution to GDP, and the possibility that real estate may not recover as strongly as in previous cycles. Nonetheless, the authorities do have fiscal and monetary headroom to respond.

Similarly, our core view remains that the risks to the financial sector relating to Evergrande are manageable, even in the event of a default. The largest banks remain well-capitalized with strong loss absorption capacity, although some other financial institutions including trust companies are more directly exposed to losses arising from any potential default.

In addition to rising credit pressures, ESG considerations have become more relevant for emerging Markets than ever. Current research shows that an overwhelming majority of public sector rating actions were driven by an ESG consideration, mostly E, but social and governance considerations were also relevant, as is highlighted in the following report:

On the topic of environmental factors, physical climate risk is broadly credit negative for sovereigns, particularly for emerging markets with climate-dependent economic structures and low-quality infrastructure and healthcare systems. This infographic gives an overview of Moody’s framework for assessing physical risk.

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However, where it comes to environmental factors, not all emerging market regions are effected equally. In fact Moody's ESG credit impact scores for Latin American and Caribbean countries highlight comparatively lower exposures to environmental risks and generally higher income levels, increasing the region's resilience to ESG risks.

The primary driver of physical climate risk is of course the volume of carbon emissions produced globally. Many of the world’s leading economies have set ambitious net zero targets but, as this podcast outlines, major nations such as China face a series of hurdles and credit implications to meet their carbon goals.