Just as the global economy was finding its footing, the Russia-Ukraine military conflict is now threatening to exacerbate the negative effects of the pandemic for many emerging market sovereigns. While the credit impact of the pandemic for emerging market sovereigns was uniformly negative, this latest shock will result in a range of outcomes that will hinder, albeit not derail, the recovery trajectory.
Direct spillover effects across the emerging market universe will vary, although risks to sovereigns from the invasion are not as broad-based as those from the pandemic shock. Sovereigns with the strongest economic and financial links to Russia and Ukraine (Caa2 review for downgrade) are most at risk of credit quality erosion, particularly among sovereigns in the Commonwealth of Independent States (CIS) and Central and Eastern Europe (CEE).
The broadest transmission channel will be through higher energy and food prices arising from the invasion. Global food prices are at record highs in nominal terms and at their highest level since 1974 in real terms. Even before the outbreak of the military conflict, unfavourable weather and higher input costs for fertilisers and energy suggested prices would remain high this year. The disruption of food supplies from Russia and Ukraine – which accounted for a combined 26% of global wheat and meslin exports in 2020 – will further compound inflationary pressures, hitting sovereigns in CEE, CIS and Sub-Saharan Africa hardest.
Assuming the global economic impact of the conflict is contained, normalization of activity and supply chains, and monetary policy tightening that curbs demand-side pressures will support a gradual easing in inflation back toward pre-pandemic rates in the second half of 2023. However, there are material risks that inflation will persist for even longer. In a scenario of persistent inflation, monetary policy credibility could be eroded, leading to higher inflation expectations and causing inflation to become entrenched, and leading central banks to raise interest rates more aggressively, or face challenges maintaining policy accommodation as economies weaken, which would reduce debt affordability. In such a scenario, emerging markets would be more exposed to rapidly rising funding costs due to weaker debt affordability relative to advanced economies.
The terms-of-trade shock created by the conflict will be greatest for food and fuel importers. Countries that rely most heavily on imported food and fuel are likely to experience the most negative terms-of-trade shock because demand for food and fuel imports will remain high even as the value of the goods and services they export declines. Net food and fuel importers will be among the worst affected. These include small island economies already struggling with the loss of tourism from COVID-19 such as the Maldives (Caa1 stable) and Jamaica (B2 stable). By contrast, commodity exporters – and major oil and gas producers in particular – will benefit from more favourable terms of trade.
On the other hand, disruption through financial channels will be manageable for all but the least creditworthy sovereigns. Emerging market sovereigns have issued more local currency debt, become less reliant on overseas investors and some have launched quantitative easing programmes, which have helped provide liquidity and market stability. Nonetheless, the outlook is less benign for frontier market sovereigns, which have seen a sharper widening of their sovereign credit spreads compared to emerging markets. Stress tests on financial conditions show that a sustained spike in borrowing costs would cause the most severe deterioration in debt affordability in Egypt (B2 stable), Pakistan (B3 stable), Ghana (Caa1 stable) and Jordan (B1 stable), while Sri Lanka’s (Ca stable) debt affordability, already the weakest by far, would weaken further.
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.
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.
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.
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.
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.
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.
On 26 January, the US Federal Reserve underscored its commitment to start hiking interest rates soon while bringing net asset purchases to a halt in March, raising the specter of another ‘taper tantrum’ – a period when emerging market currencies experienced elevated volatility and heavy selloffs after the Fed first announced it would be reducing the pace of its asset purchases in 2013.
Emerging markets are typically more exposed to the risk of a sudden stop due to their reliance on dollar-denominated external debt as a source of funding. Those with large external funding requirements and a debt stock with shorter maturities are at particularly acute risk of any sudden shift in external financing conditions, as are those with open capital markets. This includes major G-20 economies such as South Africa (Ba2 negative), Indonesia (Baa2 stable) and Turkey (B2 negative), but also smaller economies such as Bahrain (B2 negative). Many EM economies are raising domestic interest rates to contain inflation despite macroeconomic conditions remaining weak, and the prospect of higher interest rates in the US may pressure EM central banks to further tighten their monetary policy stance.
Nonetheless, several emerging markets have improved their resiliency to external funding shocks compared to 2013. For example, in the case of Egypt, local-currency bonds' inclusion in the JP Morgan Emerging Markets Government Bond Index will improve liquidity in the long-term segment of the local-currency debt market, via increased demand from index-tracking investment funds, mitigating higher borrowing costs. Furthermore, the comparatively tight monetary policy stance that the Central Bank of Egypt has maintained over the past year will mitigate pressure to increase domestic interest rates.
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.
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.
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.
Not surprisingly, the pandemic triggered a decline in FDI flows into emerging markets in 2020. However, even prior to the pandemic, aggregate FDI flows into emerging markets as a share of GDP had almost halved in the prior decade.
Why have FDI inflows declined so significantly? One of the most notable trends has been the decline on FDI returns in emerging markets. Before the global financial crisis, FDI in major EMs offered higher rates of return compared to developed markets, helping compensate investors for the additional risks associated with EM investments, such as more challenging regulatory and business environments and higher political risks. However, since 2009, returns on FDI across EMs have declined significantly, while returns on FDI in developed markets have remained relatively stable.
Weaker FDI inflows could weigh on long-term growth potential for emerging markets, given that FDI has been a key source of knowledge and technology transfer, supporting total factor productivity growth. While some countries with high domestic savings rates may be better placed to manage the impact of a decline in FDI on fixed investment, those with lower domestic savings and weaker capital markets access, such as smaller countries in Latin America and Africa, are more likely to be affected as a result of lower FDI flows.
Moreover, a protracted and uneven recovery across emerging markets, coupled with deglobalisation and growing interest in shortening supply chains to address some of the vulnerabilities laid bare by the trade tensions between the US and China, and more recently the pandemic, are among the significant headwinds that may prevent a reversal of this decline.
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.
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).
With over $90 trillion in outstanding debt, what forces will drive credit risk in emerging markets in 2022? Will credit conditions stabilize? Even as debt levels touch record highs, investors’ have shifted focus to new risks, such as inflation and supply chain disruptions. How are a multispeed recovery, high leverage, inflation, deteriorating financial conditions and other forces shaping credit risks? Which countries and sectors will lag, which will outperform? What factors set emerging markets apart?
For the full report on our outlook for all emerging markets across 107 countries and 1,800 sovereigns, corporates, and banks, click here.
Emerging Markets – Global
Despite stabilizing credit conditions overall, our outlooks for sovereigns in Sub-Saharan Africa and the Levant and North Africa are negative. In Sub-Saharan Africa, economic growth will accelerate only marginally in 2022, which will keep fiscal deficits, borrowing requirements and debt levels elevated. Without additional international support, these trends will likely weaken debt affordability and intensify liquidity and external pressure, particularly given the domestic banking systems’ limited capacity to provide finance.
The negative outlook for sovereigns in the Levant and North Africa reflects a subdued and uneven economic recovery across the region, entrenched governance challenges and elevated social pressures. Governments will struggle to maintain post-crisis fiscal discipline while confronting long-standing socioeconomic demands.
While financial conditions in emerging markets have improved relative to most of 2020 as measured by our proprietary EM Financial Conditions Indicator, they will remain tight compared with the long-term average, after a brief period of favorable conditions in April to July 2021. Many emerging market economies are raising domestic interest rates to contain inflation despite still-weak macroeconomic conditions.
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.
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.
The emerging global economic recovery has driven a sharp increase in prices across a range of commodity markets, as pandemic-related restrictions were unwound and household spending recovered. In global oil markets, Brent crude exceeded $80/bbl a barrel in October, with the US Energy Information Administration now expecting that oil demand will marginally exceed pre-pandemic levels by the end of 2022. The rally has also extended to metals and agricultural products, with copper, corn and sugar all trading above 2019 levels this year.
The rising cost of raw materials has contributed to rising inflationary pressure across the globe, adding to the challenges facing policymakers as they navigate out of the pandemic, and prompting a slew of aggressive tightening cycles for several major emerging markets, including Russia and Turkey. However, for some emerging market sovereigns, higher commodity prices have been a boon, helping to offset the lingering effect of the pandemic as they grapple with lower vaccination rates and more protracted economic recoveries.
Among the major oil producers in the Gulf Cooperation Council, the sharp reversal in oil prices this year has provided a major tailwind to government budgets, which were under severe strain last year as Brent crude dipped below $30 a barrel at points, and averaged $42 a barrel for the year. In Oman, which alongside Bahrain has experienced the most significant erosion of its fiscal strength since the structural break in oil prices back in 2015, higher oil prices have significantly improved the outlook for government liquidity and external financing pressures, a key driver behind our decision to stabilize the outlook last month.
Meanwhile in Latin America, rising commodity prices supported by improving global demand throughout 2022 will buttress credit in the metals, mining and agricultural sectors, supporting the positive outlooks in these sectors. For example, in Chile, where copper accounts for around half of total exports, we expect the rally in copper prices will support corporate profits and encourage deleveraging in that sector, supported by the improving global economy and low inventories worldwide. However, rising demand for greater post-pandemic social spending has also raised the risk of greater taxation on the sector.
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.
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.
The recovery continues to remain uneven. Case in point, South Africa is facing weak growth and social pressures threatening public-sector finances. And with challenging funding conditions, liquidity pressure is high and elevating credit risk.
However, emerging markets, even those with a relatively large tourism sector, have begun to make positive strides to revive their economies by reopening their borders and welcoming back tourists after 18 months of tight restrictions. The following two reports discuss the credit-positive implications for two tourism-dependent countries: Fiji and Thailand.
Meanwhile, Russian regions’ own-source revenue increased 27% during January-August 2021, and their expenditure growth remained contained at just 7%, driven by growing tax proceeds and cost controls, which is offsetting spending pressures from higher inflation.
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