Debate over the short- and longer-term consequences of COVID-19 dominated the Spring meetings of the International Monetary Fund, with our emerging-market debt team among those following discussions closely.
With many parts of the world, particularly emerging market countries, still in the grips of a COVID-19-driven health and economic crisis, there was perhaps even more attention on the annual Spring meetings of the World Bank and International Monetary Fund, which this year took place virtually between April 5-11.1
The IMF’s managing director Kristalina Georgieva laid bare the severity of what is at stake in her opening remarks at a press conference on April 7.2 “Economic fortunes are diverging dangerously. A small number of advanced and emerging market economies, led by the US and China, are powering ahead—weaker and poorer countries are falling behind in this multi-speed recovery,” she warned.
Policymakers must take the right actions now by giving everyone a fair shot
“We also face extremely high uncertainty, especially over the impact of new virus strains and potential shifts in financial conditions. And there is the risk of further economic scarring from job losses, learning losses, bankruptcies, extreme poverty and hunger. Policymakers must take the right actions now by giving everyone a fair shot—not just into people’s arms, but also in people’s lives and in vulnerable economies.”
‘Fairness’ was the common thread in Georgieva’s comments on the IMF’s priorities for tackling the crisis – giving countries a “fair shot” at the vaccine, recovery and the future. But not everyone was convinced that the level of ambition in the meetings matched the rhetoric.
In an op-ed published by the Financial Times3, Mark Lowcock, UN under-secretary general for humanitarian affairs, and Masood Ahmed, president of the Center for Global Development, wrote: “Maintaining the weak response we’ve seen so far would be a moral failure, and one lacking foresight. Aside from the obvious risk of leaving the virus free to circulate, it opens up the possibility of secondary crises — hunger, conflict and displacement — spilling over into the lives of everyone, everywhere.”
There remains a real risk of default in some countries
While IMF liquidity is a vital source of support to many countries, there does remain a real risk of default in some countries with little near-term prospects of recovery from COVID-19. To discuss the key insights and implications for investors from the spring meetings, we spoke with Carmen Altenkirch (CA), Nafez Zouk (NZ) and Liam Spillane (LS) from Aviva Investors’ emerging-market debt team.
Divergence and delays to recovery from the pandemic were big talking points at the meetings. What should we infer from that?
NZ: Despite increased optimism on display at this year’s meetings, there was a strong undercurrent of concern over the unevenness of the economic recovery globally. Developed markets (DM), led by the US, are expected to bounce back relatively quickly from the pandemic on account of the massive monetary and fiscal measures undertaken and an ample supply of vaccines.
Emerging markets economies are likely to face greater economic scarring than developed markets
The headwinds facing emerging markets (EM), however, are greater. With less policy space to counter the impact of the virus, EM economies are likely to face greater economic scarring than DM. Moreover, the rollout of vaccines in EM has been much slower, which will likely hamper their economic recoveries.
But even within EM, the speed and completeness of recoveries will differ. Emerging Asia has been able to bring the virus under control earlier than EM peers, and benefits from close proximity to China, where the economy has already recovered to pre-pandemic levels. But in other regions, like central and eastern Europe, a resurgence of the virus and still-low vaccination rates threatens a return to tighter and longer lockdowns.
Countries that depend excessively on tourism will likely see their recoveries delayed, while those with relatively less policy space coming into the crisis could find themselves more constrained in shoring up their economies should growth fail to pick up sufficiently. South Africa and Brazil are two notable examples.
Many emerging markets face a double-edged sword of higher US growth and, potentially, higher interest rates. Does that add to the current concern?
NZ: Higher interest rates are a natural consequence of faster global growth; some countries are in a better position to cope than others. The IMF noted the nature of the rise in yields is an important element to gauge their impact on EM economies: rate increases driven by faster growth have a more benign effect on EM capital accounts than those caused by expectations of more hawkish DM central banks.
Rising borrowing costs will aggravate concerns over debt sustainability
For EM countries, the risk is that any tightening of financial conditions coincides with slower recoveries. Countries with large external financing needs are especially at risk from a reduction in capital flows. Where these pressures combine with weak fiscal anchors and monetary policy credibility, rising borrowing costs will aggravate concerns over debt sustainability.
However, it is important to stress that initial macro conditions are more robust today in many EM countries than they were during comparable periods of sharp capital outflows, such as the 2013 ‘taper tantrum’.
Given the financial strain that many countries are under, can EM still count on IMF support?
CA: The resounding answer from the IMF meetings as well as individual country discussions is ‘yes’. The IMF is showing itself to be more proactive, more lenient, and more willing to engage on the unique circumstances facing countries than in the past. In effect, this makes it politically easier for countries to sign up to IMF programmes. Programmes are increasingly designed to preserve social spending, acknowledging the growing risk to social stability that several EM governments face.
A good example of this was the recent IMF programme in Costa Rica supporting the need for equitable fiscal consolidation, which protects the poor and vulnerable as well as the authorities' aim to decarbonise the economy.4
Will the short-term liquidity support provided by the IMF be enough to prevent more sovereign defaults?
CA: The potential extension of the debt service suspension initiative (DSSI) framework and increase in special drawing rights (SDRs) both help reduce short-term liquidity pressures facing countries. They essentially will provide much-needed policy space to fight the pandemic and limit the risk countries are pushed into defaulting.
The DSSI and SDRs provide much-needed policy space to limit the risk countries are pushed into defaulting
The IMF plans to add $650 billion to SDRs: this would see more than $50 billion – around five per cent - added to the reserves of high yield EM countries. That would be a sizeable increase in foreign exchange at a time when most high yield countries are looking to bolster their war chests. The DSSI allows the lowest-income countries who request it to take a holiday on their interest payments to loans from G20 countries, including China.
The IMF, World Bank and G20 are all instrumental in providing ongoing liquidity support to avoid what could have been a spate of messy defaults across EM. Pakistan and Angola are good examples of countries that could have defaulted, but liquidity support and prudent policies now make default a lower risk in the short term.
At the same time, neither SDRs nor the DSSI address the growing solvency risks facing a number of high yield countries – namely, a combination of wider fiscal deficits, high and rising interest costs and already high debt levels.
How can countries close the fiscal gap? How much of a factor is their credibility among investors?
CA: The IMF’s message so far has been to consolidate only once the recovery is well underway, rather than aggravate the scarring and higher poverty and inequality caused by the pandemic. Many emerging countries increasingly face a trade-off between continuing to support their economic recoveries and undermining fiscal resilience over the medium term.
That situation could turn more precarious in highly indebted EM countries and frontier markets, particularly those with high financing requirements and short maturities. Low global rates are not guaranteed, while market access may become more limited.
Make credible commitments now in exchange for fiscal consolidation later
The IMF suggests bolstering fiscal credibility or introducing ‘commitment’ devices might buy countries more time, for example pre-approving future tax reforms or strengthening rules-based fiscal frameworks. In other words, make credible commitments now in exchange for fiscal consolidation later.
Improved credibility could help close the funding gap now, not only in terms of improving market access, but helping reduce the risk premium countries pay to issue. Oman’s home-grown fiscal consolidation plan, as well as Kenya’s decision to sign up to a precautionary fund programme underpinned by a commitment to back-loaded fiscal consolidation, are good examples. High and rising financing costs are a key concern, however, particularly for countries at high risk of debt distress.
What solutions to the debt sustainability problem were discussed during the meetings?
CA: A poll of participants at the meetings showed more than 70 per cent found high and rising debt levels are a growing problem within EM. This is hardly surprising when 56 per cent of low-income countries are either at high risk of debt distress or already in distress.
There are three ways to get out of a debt trap. Debt traps tend to feed on themselves: higher debt equals lower growth; lower growth equals higher debt. The most desirable solution is to kick start higher growth, and a key theme of the meetings was building back better, stronger and greener. Fiscal austerity will come, but the IMF acknowledges this is hard during the pandemic, particularly given the dramatic setback to poverty.
The IMF emphasises pre-emptive and sustainable debt restructuring
For countries in a debt trap, where growth does not recover or fiscal consolidation on the scale required is not possible, the IMF emphasises pre-emptive and sustainable debt restructuring. It advocates for the new common debt framework, where the burden of restructuring is shared equitably across creditor groups. The extent to which the private sector, mainly bondholders and banks, can be co-opted in remains a contentious issue, however; undermining the private sector’s willingness to lend could ultimately curtail future investment.
Six countries defaulted during the immediate fallout from the COVID-19 crisis; however, all six were at high risk of defaulting in the coming years, irrespective of the pandemic. Despite the sharp increase in debt over the past year, only Ethiopia has pre-emptively defaulted. We also see a high probability Sri Lanka will be forced into defaulting over the coming year. The extent to which we see a series of new countries pushed into default will depend on how quickly growth picks up and remains high, whether borrowing costs remain contained and liquidity support is sufficient to cover the gap.
Climate change was a key theme at this year's meetings; how important is green financing in addressing post-COVID challenges?
LS: Climate change poses challenges for many developing countries given the transition risks and costs associated with fossil fuel dependency. Recent growth in green and social bond issuance in EM is a positive step towards addressing some of those climate financing needs; however, issuers need to strike the right balance between short-term financing objectives to support stimulus plans and longer-term financing requirements tied to climate change and other Sustainable Development Goals.
Ongoing engagement with EM issuers will be important for investors
Ongoing engagement with EM issuers will be important for investors to understand how that balance is struck and whether recent issuance trends evolve into a broader and deeper suite of financing vehicles, such as sustainability-linked or transition-linked bonds, as seems likely.