Emerging countries: some things to keep an eye on

Different types of external shock

A brief overview of what might be in store for these countries over the coming months (and which they have already partly been experiencing over the past two months): in the short term, withdrawals of portfolio investments, difficulties refinancing external debt and currency attacks. They already experienced almost all of this in March, with sovereign spreads reaching an all-time high, central banks forced to defend their currencies, and withdrawals of portfolio investments estimated by the IMF at $100 billion, three times more than during the 2009 crisis…

Now, let us not be naive: even though sovereign spreads are coming down, some exchange rates are less under pressure and the price of oil is going back up, we must keep in mind the prudent assumption that emerging markets may be subject to further bouts of volatility this year, even if on a smaller scale and less indiscriminately. This assumption is, of course, linked to the growth shock, which will be severe for virtually every one of these countries (unlike in 2009, emerging countries will be in recession), but it is linked even more closely to their external accounts. Even in the best case scenario whereby GDP growth quickly bounces back in 2021, current account deficits will take longer to come down, subject as they are to greater inertia. Furthermore, many emerging countries’ external surpluses had already been gradually decreasing long before the advent of COVID-19. This is a longstanding trend: surpluses have never managed to return to their pre-2009 levels.

In the medium term, other structural problems could also cause external deficits to deepen. For example, revenue from direct foreign investment could be repatriated, and direct investment itself could potentially even be withdrawn (though this is quite rare due to the high cost of pulling out). There is also the slowdown in trade, the more or less lasting decline in tourist revenue, the crisis in certain sectors (automotive, air travel, shipping, etc.), the issue of commodity prices (oil first and foremost) and a shock arising from the repatriation of foreign worker’s income; the World Bank estimates that migrants have sent home some $554 billion dollars – more than the total amount of foreign direct investment received by the affected countries…

Given this avalanche of potential shocks, the question of financial risks is a major one. It revolves around exchange rates and debt, solvency and liquidity, all of which are important in identifying not only the highest-risk countries or actors (governments, households, companies and banks) but also potential systemic chain reactions. It is not our intention to answer these questions, which will keep us busy for several months (if not years), in a few short lines. Our aim is simply to highlight a few key things to keep an eye on this year.

An end to the original sin for public debt?

When it comes to public debt, the BIS[1] and the IMF[2] are in agreement: almost all emerging countries have got over their “original sin”[3] , which had been leading them into crises since the 1980s. At the end of 2019, 80% of emerging countries’ public debt was financed in local currency, most of it at fixed interest rates. This limits their vulnerability to foreign exchange risk as well as limiting the risk of a systemic crisis affecting emerging public debt.

There are, however, still risks, as the BIS points out. This is partly because the average stock of emerging countries’ public debt has tended to increase (though it is lower than that of non-emerging countries). It is also because some countries have kept a portion of their public debt – between 10% and 20% of the total – in foreign currency, with the result that they continue to be exposed (setting aside those in default, countries that do this include, among others, Hungary, Turkey and Mexico). Moreover, the BIS also highlights the vulnerability of large public corporations in this area: they are much more exposed than sovereigns, especially in commodity-exporting countries. This is because corporations are “naturally hedged” against foreign exchange risk precisely because they are exporters – the very reason for which they were able to borrow in foreign currency! This situation becomes dangerous if the price of the commodities they export becomes structurally lower.

Another thing to keep an eye on: foreign investors’ participation in local sovereign debt markets, which has risen from an average of 10% in the 2000s to 25% today (obviously with very large divergences between countries). The IMF thinks such participation can be a good thing in that it can help countries achieve greater financial depth and lower volatility, but that it turns into a risk of higher volatility when this participation exceeds 40% of the total, or at times of global financial stress. Investors then become importers of global shocks, all the more so given that debt flows are highly sensitive to international conditions while equity flows are driven more by local conditions – notably growth in the country in question.

Lastly, the BIS sounds the alarm over an obvious issue: the overall increase in countries’ short-term funding requirements, which it estimates will amount to between 10% and 20% of GDP for the hardest-hit countries. And this is happening in a context where countries that were right on the edge of what international rating agencies consider investment grade risk being downgraded, which could trigger a kind of “rating shock”. That sums up the situation as far as countries are concerned.

Watch out for private sector debt

What about other actors? To start with, let’s consider one of the most worrying – and, unfortunately, the most opaque – areas of risk: the matter of private debt issued by non-financial corporations in emerging countries. The IMF has been sounding the alarm over this issue for several years, with debt equating to over 100% of GDP in many countries: China, obviously, but also Turkey, South Korea, the Czech Republic and others besides. However, this figure needs to be put into perspective by considering only the foreign currency portion of this private debt relative to GDP. When we do this, China disappears from the risk sample, leaving countries like Turkey, Mexico, Chile, the Czech Republic and Malaysia.

However, the BIS also points out what can attenuate the risk arising from this private debt: foreign currency assets held by the same emerging country corporations, which reportedly amount to $1,000 billion deposited with the institution’s correspondent banks. It also believes Hungary, the Czech Republic, Chile and Malaysia each hold foreign currency assets equivalent to over 100% of GDP. And it believes some countries’ regulatory institutions are themselves very careful to ensure that corporations with debt are adequately covered (one example being the Central Bank of Chile). The BIS nevertheless warns that $200 billion is due to be repaid between June and December this year by corporations in Brazil, China, India, Mexico, etc.

Lastly, it is important to point out that all these vulnerability analyses depend, above all, on one thing: how long the crisis lasts. This is where Barry Eichengreen[4] – who came up with the idea of emerging countries’ “original sin” – comes in . He thinks there will be many structural factors at play, such as a lower price equilibrium for oil, reduced trade and restructured value chains. And he calls our attention to another old original sin: the fact that international institutions systematically misread the crisis when it comes to debt, focusing too much on the short term and on boosting liquidity, starting from the assumption that the problem is a temporary one; in reality, what is needed is to think about the long term now, in light of structural trends.

(1) Banque des règlements internationaux – Quaterly review – Juin 2020
(2) FMI – Global financial stability report – Avril 2020
(3) Une incapacité de l'État à emprunter à long terme dans sa propre monnaie, connue dans la littérature sous le nom de péché originel (original sin, Eichengreen et al., 2002)
(4) Managing the Coming Global Debt Crisis, Barry Eichengreen, Project Syndicate, 13 May 2020

Tania Sollogoub - Tania.sollogoub@credit-agricole-sa.fr