Relatively low vaccination rates, slowing Chinese growth, and terms of trade gains that may have largely peaked mean emerging market economies face several headwinds in 2022. Varying degrees of resilience and vulnerability are likely to result, argue Nafez Zouk and Carmen Altenkirch.

While economic growth rebounded sharply across developing economies in the first half of 2021, forecasts for several countries have been revised down since June. This follows concern over the impact of fresh outbreaks of COVID-19, especially in countries with low vaccination rates.

The economic consequences of lagging EM vaccination rates are all too evident

The economic consequences of lagging emerging market vaccination rates – as highlighted in Figure 1 – are all too evident, with increased risks of economic scarring over the medium-term.

Figure 1: EM and DM (per cent share of population fully vaccinated)
Source: Macrobond, October 2021

There are also growing concerns about the potential ripple effects of a cooling Chinese economy; again, the impact will not be uniform across emerging markets. Countries such as Peru, Chile and Brazil are heavily dependent on Chinese demand for commodity exports, Thailand relies on Chinese tourists, and supply chains in the Philippines and Malaysia are deeply intertwined with the Chinese economy.

There are growing concerns about the potential ripple effects of a cooling Chinese economy

Other countries are in a better position to weather a slowdown in China. Mexico and Eastern European countries stand out, given their respective proximity to large manufacturing centres in the US and Europe.

There are two additional external headwinds. The first stems from the prospects of tighter US monetary policy, including imminent tapering of the Federal Reserve’s asset-purchase programme and a likely increase in policy rates next year. History suggests tighter financial conditions in the US have financial consequences for EM given the impact on capital accounts.

Meanwhile, the recent (and wholesale) improvements in current account balances may wane in 2022 as commodity prices come off their highs and import demand picks up. Taken together, it will prove more challenging for more vulnerable EM countries to meet their financing needs.

The cost of economic recovery from COVID-19

The quick rebound and resilience of EM economies in the face of COVID-19, despite the rapid deterioration in government finances, is largely down to three factors:

  • Low bond yields in developed nations have helped suppress yields elsewhere, enabling most countries to continue accessing capital markets
  • Intervention from the International Monetary Fund (IMF), which stepped in with rapid support measures as economies contracted severely due to COVID-19. Since the start of the pandemic, the IMF has provided $110 billion in new financing to 86 countries and, more recently, allocated $650 billion in Special Drawing Rights (SDRs). Of this, 40 per cent went to emerging and developing countries; in effect, free money from the IMF is being used in some countries to support reserves and for budgetary purposes
  • The introduction of domestic quantitative easing programmes by some EM central banks
EM government debt is set to climb to nearly 70 per cent of GDP by 2026

However, as in the developed world, the governments of poorer nations have resorted to issuing large amounts of debt to support economic activity. Sovereign debt-to-GDP ratios, which ballooned to a record high in 2020, look set to go on rising as policymakers struggle to get a grip on their finances. According to the IMF, EM government debt is set to climb to nearly 70 per cent of GDP by 2026, up from 51 per cent in 2018.

Frontier economies are in an even more precarious position; according to our calculations, 22 have debt-to-GDP ratios above 70 per cent, compared with just seven in 2015. Anything above 70 per cent has historically been the point where debt sustainability concerns have tended to kick in.

Figure 2: Sovereign debt in EM: IG versus HY (per cent of GDP)
Source: Aviva Investors, October 2021

A formula to estimate debt sustainability

That said, not all EM countries are created equal. Some markets look more vulnerable should economic growth disappoint or if the Fed, as expected, starts to withdraw some of the monetary stimulus that has been in place since last spring.

Several factors need to be assessed when gauging a country’s vulnerability to default or distress; one of the most crucial considerations is its ability to grow economic output. To assess whether public debt is on a sustainable path, it is possible to carry out simple simulations using the following equation:

dt = debt-to-GDP ratio in period t
dt-1 = debt-to-GDP ratio in period t-1
rt = real interest rate in period t
gt = real GDP growth rate in period t

pt = primary budget balance as a per cent of GDP in period t

A change in a country’s debt-to-GDP ratio between one year and the next depends on four variables

Essentially, the equation states that a change in a country’s debt-to-GDP ratio between one year and the next depends on four variables: the current debt-to-GDP ratio, real rate of interest, real rate of GDP growth, and primary budget balance (the government’s fiscal position excluding interest payments).

In simple terms, if a country’s real economic growth rate does not exceed the inflation-adjusted cost of servicing its debt, it must run a primary budget surplus to keep its debt-to-GDP ratio stable. The more growth lags debt interest costs, the bigger the primary surplus the country needs to run to keep its deficit in check.

Likely winners and losers

When mapping these variables  onto Figure 3, it is possible to get a feel for which countries have less to worry about and which look more at risk, especially those whose governments are unwilling or unable to consolidate their finances.

Most countries lie in the area shaded green, where real economic growth is likely to exceed real effective interest rates. The bulk of these countries should be able to generate sufficient growth to reduce debt, assuming they don’t take their eye off fiscal consolidation. Malaysia and Indonesia are cases in point. While fiscal consolidation is needed in both countries to prevent debt from rising, strong economic growth means they may have more leeway than peers.

Peru, Colombia, Ukraine, and Ghana are all vulnerable to growth disappointing

Nevertheless, others in the area shaded green could quickly find themselves in trouble should economic growth fall short of expectations. The likes of Peru, Colombia, Ukraine, and Ghana are all vulnerable to disappointing growth; as such, investors will need to watch fiscal metrics closely to better assess their future debt trajectory.

Some nations are in an even worse position. Romania, the Czech Republic and Bahrain all lie in the area shaded amber. Although it would take a big negative economic shock to cause serious concerns for Romania and the Czech Republic, the same cannot be said for Bahrain, whose fiscal position merits closer monitoring. As for South Africa and Brazil, which both lie in the area shaded red, real economic growth will almost certainly be insufficient to prevent large primary deficits from putting upward pressure on debt-to-GDP ratios.

Figure 3: EM debt dynamics: r-g versus primary balances (2022-26)

EM debt dynamics: r-g versus primary balances

Source: Aviva Investors, October 2021

Since the pandemic erupted in early 2020, emerging market bonds have enjoyed several tailwinds that continued longer than might have been envisaged.

Unless they can keep growing their economy, some countries could be heading for trouble

These tailwinds will not disappear overnight and so most countries will continue to be able to fund their deficits without much difficulty. But in a minority of cases, investors will need to keep a close watch on the variables underpinning fiscal deficits. Unless they can keep growing their economy, some countries could be heading for trouble. As Warren Buffet famously put it, “only when the tide goes out do you discover who’s been swimming naked”.

The long-term threat of climate change to EMD

Looking further ahead, there is concern about EM countries’ ability to pay for the costs of tackling climate change. According to a report published in June by the International Energy Agency, in collaboration with the World Bank and the World Economic Forum, poorer nations need to invest over $1 trillion a year by 2030 in developing clean energy if the goal of net-zero global emissions by 2050 is to be met. That would represent an increase of more than seven times the current level of investment.

The report said unless much stronger action is taken, energy-related carbon dioxide emissions from poorer economies – which are mostly in Asia, Africa and Latin America – are set to grow by five billion tonnes over the next two decades.

While it is far from certain poorer countries will be able to match the level of ambition being demanded of them, the risk they will be required to contribute towards the cost of this energy transition is presently being overlooked by markets.

According to the report, sub-Saharan Africa could be facing a bill of as much as five per cent of GDP by 2026, almost three times as much as the region receives annually in foreign direct investment (FDI). Such a number would clearly be unsustainable if funded entirely by the public sector. While most of the bill will inevitably have to be paid via FDI, EMD investors will need to pay much closer attention to the impact of climate change on public finances over the coming years.

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