Emerging markets (EM) are at a crossroads. The impact of COVID-19 aggravates pre-existing challenges. But it also enables those EM economies that respond effectively to create better conditions for the future.
EM authorities face critical policy decisions. Certain growth-dampening secular trends underway before the COVID-19 crisis are now set to accelerate. Faster deglobalization and even greater debt accumulation seem inevitable. These global trends might be unstoppable, but the speed and quality of EM responses will, in our view, be critical in shaping the medium-term trajectory of the asset class and in separating the winners from the losers.
In the early phases of the crisis, the combination of a deep global economic recession and an unprecedented global pandemic wrong-footed EM and placed them in the crosshairs of criticism.
EM Economies Could Reopen Swiftly
The unpredictable nature and magnitude of this economic shock justify unprecedented policy support. The coronavirus crisis directly affects lives and livelihoods. And for many poorer EM countries with limited ability to cushion the economic impact of COVID-19, these two concepts are inevitably very closely related.
So for EM, the point at which the costs of economic lockdown potentially outweigh the benefits of flattening the COVID-19 curve arrives more rapidly than for advanced economies. As a result, we think it is possible that EM countries could reopen their economies relatively swiftly. While this approach may be risky, it could put EM countries in a relatively strong economic growth position.
In the early phases of the crisis, the combination of a deep global economic recession and an unprecedented global pandemic wrong-footed EM and placed them in the crosshairs of criticism. Some early proposals to alleviate the liquidity crunch made matters worse: they were vague, unconventional, and/or impractical. But soon after, liquidity improved because of rapid multilateral support, short-term official bilateral debt relief, enhanced dollar availability via swaps, and idiosyncratic policy responses.
And now, encouragingly, high-yielding sovereign-debt issuers have started to return to international capital markets. Short-term risks remain as EM economies emerge from lockdown. Overall, we think emerging markets’ medium-term value proposition is now quite compelling, but each country will follow a different path and require specific analysis.
Debt Relief Can Be Managed Effectively
In response to COVID-19, the International Monetary Fund (IMF) stepped up its support for EM sovereign debtors by granting numerous large rapid financing programs. The G20 bilateral debt relief agreement gives eligible low-income countries an additional short lifeline.
But the G20’s appeal to private creditors to provide comparable relief has unnerved investors somewhat. Not only are there legal and practical complexities, but there’s also the risk of unintended consequences. From the debtors’ perspective, those consequences could include credit-rating downgrades and loss of market access. This probably explains why by late May, only about 30 percent of the countries eligible for official bilateral debt payment forbearance requested it.
However, there is an encouraging precedent for the debt relief of poor countries. The IMF and World Bank launched the Heavily Indebted Poor Countries (HIPC) initiative in 1996 to ensure that poor countries were not being overburdened by debt. The positive results saw debt-service burdens decline, supporting economic growth and freeing resources for social spending.
Like the current debt relief proposal, private creditor participation in the HIPC initiative remains voluntary. The HIPC initiative has seen lackluster participation from non-official creditors, and we expect to see the same from the latest debt-relief program.
We believe outright multilateral support and official bilateral debt relief are the best solutions. They enable rapid liquidity relief, uniform accountability criteria and solid guard rails to protect against moral hazard. With these foundations in place, private creditors should be keen to participate in providing liquidity to EM countries through new bond issuances.
EM Central Banks Must Choose Their Policy Tools Carefully
EM central banks have been lowering policy rates in the face of currency weakness. We think this is sensible for several reasons: the projected record contraction in economic growth; strong disinflationary forces; and monetary policy space exceeding fiscal policy space in many countries. There is also more room for EM central banks to maneuver because developed market (DM) central banks have cut interest rates aggressively, and are now considering pushing the policy envelope further as they confront the zero nominal lower bound.
More controversially, a growing number of EM central banks are also entering uncharted territory by buying government bonds. There are arguably two motivations for pursuing this strategy. The first is to finance growing budget deficits. The second is to temporarily ease bond market dislocations caused by uncontrolled portfolio outflows.
From a bullish perspective, if these bond-buying programs turn out to be a temporary feature, then risk premiums—especially in the foreign exchange market—should compress. But on a more bearish view, the outlook would darken if these unconventional strategies blur the lines between monetary and fiscal policy. The risk: policies that started out as technocratic decisions could become political tools. So bond-purchase programs could ultimately become a test of central bank independence.
Quantitative easing is now a conventional policy tool for DM central banks, but we think it is quite risky to try in EM economies, where monetary and fiscal policy coordination could be more challenging. The relative performance of currencies within EM will probably be significantly influenced by the motivation and duration of their central banks’ bond-purchase programs.
The Crisis Could Be a Catalyst for Change—And A Fork in the Road
It is too early to quantify COVID-19’s full economic impact, because the speed and effectiveness of economic reopening are uncertain and because negative secular trends have likely been fast-tracked.
The EM trajectory will, as always, be a derivative of advanced economy trends. But COVID-19 has created peculiar challenges for EM economies, and the quality of their policy responses might be even more important than before. Policymakers will misstep, possibly exacerbating divergences in credit quality and asset prices as a result.
EM countries that use the crisis to break ideological shackles could take a turn for the better, while those that use the crisis as cover to free-ride on debt relief measures or pursue risky unconventional policies are more likely to relapse. While skeptical investors remain focused on potential losers, we think the naysayers might not be paying enough attention to the potential winners.
About Adriaan du Toit
Adriaan du Toit is a London-based Sub-Saharan Africa economist with AB (Alliance Bernstein).
Photo: Danish Siddiqui/Reuters