The Emerging Market crisis that never was

Emerging markets (EM) have been regarded as a high risk, and predominantly risk-on asset class, when the Covid crisis occurred in Q1, 2020^[1]. Fears centred on the risks of deep contagion across the asset class, characteristic of previous crises in the late-1990s, and during the GFC, should cross-border capital flows collapse, after Lockdowns and extreme risk aversion.

Unsurprisingly, given the scale of the Covid and Ukraine shocks, and impact on cross-border capital flows, some EM sovereigns suffered deeply challenging external financing conditions and very weak currencies, with high profile sovereign defaults (notably Sri Lanka, Argentina, Ukraine and Russia). Clearly, the Russian and Ukrainian defaults are directly war-related, and very different from the August 1998 Russian default, which followed massive capital flight and the Asian financial crisis in 1997 (beginning with the collapse of the Thai baht in July 1997). But as we pointed out in a previous paper, EM fixed income has evolved into a different, and more robust, asset class than the 1990s version.^[2]

A key feature of EM fixed income performance since Covid is limited contagion and more tiering of credit spreads, to reflect underlying debt fundamentals and access to external financing, when compared with previous shocks. This tiering of spreads was evident between IG and sub-IG issuers, particularly those of CCC rated sovereigns, in the initial aftermath of Covid. There are good reasons for this.

Firstly, central banks of higher rated EM sovereigns adopted a form of Quantitative Easing (QE) by buying local currency sovereign bonds to reduce market strains in the aftermath of Covid, notably Colombia, Indonesia, Mexico, Poland, South Africa, Turkey and the Phillipines^[3]. This policy option was not available to EM sovereigns unable to issue local currency bonds.

Secondly, the maturity and currency composition of sovereign issuers’ debt reduced market and refinancing risks. The profile of higher grade EM debt has longer average maturity and a lower share of foreign-currency issuance than previously, dampening external and domestic shocks. Prior to Covid, EM investment grade issuers lengthened the maturity of their debt to over 8 yrs between 2000 and 2019, whereas sub-IG issuers suffered a shortening in the maturity of their debt from 5.8 to 4.5 yrs^[4], increasing re-financing risks.

In addition, between 2000 and 2019, 90% of EM debt issuance was in local currencies^[5]. EM issuers in Asia particularly reduced reliance on dollar denominated debt, and currency exposures, after the late-1990s crises (which were driven by a currency mismatch in assets and liabilities). In fact, local currency issuance reached 97% in EM Asia in 2020, in the wake of Covid.

A third factor reducing the Covid impact has been the improved external account and reserves position, compared to the GFC^[6]. Current accounts improved in more than 50% of EM economies in 2020, as imports contracted and demand from advanced economies rebounded after substantial QE and fiscal stimulus in the OECD.

Fourthly, official support to EM economies helped boost external reserves, with an SDR allocation to EM of $224bn in 2021. Indeed, the IMF^[7] estimated that by end-2021, 58% of EM economies had external reserves exceeding 100% of the IMF’s reserve adequacy measure. G7 official support was quickly extended to dollar swap lines, in the aftermath of Covid, as central banks sought to avoid a repeat of the GFC.

Fifthly, on economic policy, EM central banks tightened earlier to counter the inflation spike than the G7, where tightening only began in Q4, 2021 (in the UK). Brazil, for example, began raising rates in March 2021, from the historic low of 2%, reaching 13.75% in December 2022. But note EM central banks also adopted inflation targets earlier than Developed Markets^[8], in the late-1990s, admittedly under financial market pressure after the 1990s crises.

Taking these factors together, the lack of pronounced contagion within higher grade EM sovereigns, or a major spike in EM sovereign bond spreads after Covid, is less surprising. Chart 1 shows spreads on EM debt widened less after Covid than during previous “risk-off" episodes, like the Taper Tantrum in 2013, and the renminbi devaluation in 2015.

 The introduction of China to the FTSE Russell EM Government Bond Index (EMGBI) in 2018, with its high weight is another factor in this, dampening the high-Beta, pro-cyclical spread widening of previous cycles (see Charts 2 & 4). But in the period following Fed QE, there may also have been powerful spillover effects and capital flows helping drive EM yields lower^[9].

EM bond markets have remained resilient since the Ukraine shock and during G7 policy tightening in 2022/23, when financial conditions tightened. This reflects the disparate nature of the EM asset class, whereby major commodity exporters benefitted from higher commodity prices, even if commodity and energy importers, like Sri Lanka, suffered high profile defaults.

Chart 3 shows relative index performance of the EMGBI (local currency) index, the EMGBI capped^[10] index (EMGBIC), Frontier Emerging govt bond markets (FRNTEMGBI), and World government bond index – developed markets (WGBI-DM) since Covid in US dollar terms. It shows the impact on Frontier^[11] EM economies of the Ukraine shock and onset of US Fed tightening in Q1, 2022 - a much faster, and more severe policy tightening than the 2004-06 cycle.

Note that even the EMGBIC, which restricts country weights to a 10% maximum (and excludes the “China effect “ in enhancing EM performance returns) comfortably outperformed the WGBI-DM, with its high G7 weighting of 97.2% (Apr 2023).

The shorter duration of the FTSE EMGBI in local currency also protected investors, compared to longer duration G7 markets, which dominate WGBI-DM. Indeed, variable correlations of EM fixed income with other asset classes increase the portfolio diversification benefits of EM fixed income for an investor. Chart 4 shows the impact of duration on annualised investment returns since Covid, most notably on WGBI-DM and EMGBI. Frontier EM underperformed but this reflects weak performance at the country level, notably in Columbia, Hungary and Turkey, and higher sovereign defaults in the asset class. Even so, the Frontier EM index still outperformed WGBI-DM.

The difference in the performance of the EMGBI and EMGBI-capped, largely reflects the high-country weight of China in the EMGBI (nearly 60%). China’s lower volatility reduced volatility in the EMGBI and increased returns, since the PBOC was able to ease rates in 2022, when the Fed and other G7 central banks were raising rates.

Low correlation of the Chinese onshore govt bond market with the G7 has weakened the linkage between higher Fed interest rates and EM. It might also explain the asymmetry observed in the correlation of EM yields to the US, rising during periods of falling yields, and vice versa.

With evidence emerging of inflation declining globally, as commodity prices fall back, and growth forecasts for 2023 being upgraded modestly (eg, the IMF), EM central banks are now relatively well placed, having begun policy tightening cycles in 2021, a full year ahead of the G7. In fact, the global inflation shock in 2022/23 never materialised in Asian EM economies, allowing the PBOC to ease policy in China in 2022.

Having survived much of the impact of Covid in 2020/21, and the worst of the Ukraine shock, higher grade EM debt markets may be well positioned to attract increased capital inflows, as G7 tightening cycles near completion.

Absolute yields are at the higher end of the ranges since 2018, even if spreads narrowed in 2022/23.

[1] See Absolute Strategy Research, “Prepare for an EM default wave”, April 22, 2020

[2] See “ Emerging Market Fixed Income; Development and Characteristics of the asset class, “ Robin Marshall, FTSE Russell, May 2020.

[3] See Cantu, C.et al (2021), “ A global database on central banks’ monetary responses to Covid-19”, BIS Working Papers, Vol. No 934.

[4] OECD (2020), “ Sovereign Borrowing Outlook “, Vol. Special Covid-19 Edition

[5] OECD (2020), “ Sovereign Borrowing Outlook “, Vol. Special Covid-19 Edition

[6] IMF Working Paper, Feb. 2022, Emerging Markets, Prospects & Challenges.

[7] See footnote 5 above, page 10.

[8] F. Mishkin, Inflation Targeting in Emerging Market Countries, NBER Working paper 7618, March 2000).

[9] See “ Effects of US quantitative easing on emerging market economies“ , Saroj Bhattarai, Arpita Chatterjee, Woong Yong Park, Journal of Economic Dynamics and Control, January 2021.

[10] EM sovereign weights capped at 10% of overall index.

[11] FTSE Russell frontier EM index constituents are markets that are not yet mainstream EM, typically have a very active investor base, with minimum requirements for foreign investors to transact. Also see Meeting investors’ needs in Emerging Markets Fixed Income | FTSE Russell.