We assess the near and longer-term implications of Russia’s invasion of Ukraine on emerging-market debt.

Read this article to understand:

  • What the short-term reaction in EMD to the Ukraine-Russia crisis looks like in a longer-term context
  • The impact of sanctions on Russia and the key ESG considerations
  • How the crisis has impacted our view on EMD

The Russian invasion of Ukraine, which began on February 24, serves as a stark reminder of the unpredictable nature of geopolitics and the effect it can have on economies and financial markets, including emerging-market debt (EMD).

In this article, we look to answer some of the key questions for EMD investors on the implications of the crisis.

In doing so, it is important for us to repeat our public position on the conflict: First and foremost, we are extremely concerned at the events unfolding in Ukraine and our thoughts are with all Ukrainians at this time. Further details on Aviva Investors’ position can be found here.

1. What has the market reaction been so far?

Whilst it is hard to be exact with bond prices given current volatility, Figure 1 gives a guide to the impact of recent events on the main EMD indices.

Figure 1: Index returns (per cent)
Index returns
Indices referred to are the JP Morgan EMBI Global Index, JP Morgan CEMBI Broad Diversified Index, JP Morgan GBI EM Global Diversified Index. Past performance is not a guide to future returns.
Source: Aviva Investors and JP Morgan. Data as of March 15, 2022

Hard-currency sovereign spreads have moved over 70 basis points (bps) wider since the end of February; corporate spreads have moved by over 100bps. Nevertheless, the moves in the broader EMD market overall remain far smaller than when Russia annexed Crimea in 2014.

Part of the reason for the more limited reaction in spreads this time around can be attributed to the lower weighting of Russian issuers within the main emerging market (EM) indices. In 2014, Russia constituted ten per cent of the sovereign index and 12 per cent of the corporate index; at the end of January 2022, Russia only accounted for around three per cent of both the sovereign and corporate indices. The change in Russia’s weighting in the local currency index has been less significant; moving from around ten per cent in 2014 to 6.8 per cent at the end of January 2022.

Figure 2: EMD valuations
Indices referred to are the JP Morgan EMBI Global Index, JP Morgan CEMBI Broad Diversified Index, JP Morgan GBI EM Global Diversified Index. Past performance is not a guide to future returns.
Source: Aviva Investors and JP Morgan. Data as of March 4, 2022

2. How do drawdowns look versus history?

Given the market moves in recent weeks, it is easy to get caught up in daily and intraday market moves and be tempted to de-risk portfolios. Putting recent moves into their longer-term context can help illustrate the benefits of resisting that temptation, especially in an asset class such as EMD.

Since 1994, there have been twelve drawdowns of greater than five per cent

Since the inception of the hard-currency index in 1994, there have been eight drawdowns greater than ten per cent and twelve drawdowns of greater than five per cent. Over the same period, the index has returned a cumulative 744 per cent, including the recent ten per cent conflict-induced sell off.

Figure 3: EM index drawdowns (per cent)
Past performance is not a guide to future returns.
Source: Aviva Investors, Bloomberg, JP Morgan EMBI Global Index. Data as of February 28, 2022

Figures 4 and 5 highlight not just the extent of the drawdowns experienced by hard currency EMD investors, but also the rapid nature of recoveries. Looking at the most significant drawdowns on the index (greater than ten per cent), the average recovery period was eight months from the trough of the drawdown.

Figure 4: Largest EM drawdowns
Largest EM drawdowns
Past performance is not a guide to future returns.
Source: Source: Aviva Investors, Bloomberg, JP Morgan EMBI Global Index. Data as of March 4, 2022

3. What have been the main sanctions imposed on Russia?

Russia has been cut off from approximately 60 per cent of its foreign currency reserves

There are two common threads running through the sanctions announced since the invasion: export controls to limit Russia’s ability to access technology in key sectors (e.g., oil, aviation, military) and financial restrictions, for corporate and banking sectors.

Both types of sanctions have had a severe impact on Russia’s economy:

  • Banking restrictions: Including SberBank and VTB – Russia’s largest two banks. Sanctions include asset freezes, restrictions on the ability of banks to transact in US dollars and partial bans on using the SWIFT financial messaging service
  • Debt/equity restrictions: Blocking issuance of debt/equity for a range of banks and companies
  • Sovereign debt: Restrictions on primary market (already the case for the US) and secondary market trading for debt issued from March 2022
  • Central bank: Foreign assets of the Russian central bank have been frozen, cutting Russia off from approximately 60 per cent of its foreign currency reserves

However, the sanctions allow for carve outs for energy and for agricultural and medical commodities.

Russian financial institutions conduct about $46 billion worth of foreign exchange transactions daily, 80 per cent of which are in US dollars. Most of those transactions will now be disrupted.

4. What impact will sanctions have on Russia?

The announced sanctions will have severe economic repercussions.  Those targeting the central bank’s assets will significantly erode the buffers built up in the “fortress” strategy adopted by Russia since 2014 – namely the accumulation of $630 billion in reserves and $180 billion in the sovereign wealth fund – undermining Russia’s capacity to respond to financial pressures in the short term.

The ability and willingness of Russia to honour its external commitments has eroded significantly

The composition and location of reserves is also important given recent asset freezes and Russia’s exclusion from USD clearing/ settlement. Russia in recent years has moved a large proportion of its reserves onshore (just under 50 per cent), has diversified its holdings away from US dollars (now 16 per cent of the total) into euros (33 per cent), CNY (14 per cent) and gold.

The ability and willingness of Russia to honour its external commitments has eroded significantly – credit rating agencies have slashed Russia’s sovereign rating by up to eight notches.

In the longer term, sanctions will also erode Russia’s economic prospects, given the announced restrictions on foreign financing, technology and resources needed for the continued operation and development of key sectors combined with significantly tighter financial conditions.

5. What about Russian corporates?

Signals from the corporate sector have been mixed. Gazprom, the Russian energy company in which the state holds a 50.23 per cent stake, paid back its dollar bonds that matured in March, while Russian Railways (also state owned) missed a coupon payment.

Fitch has so far downgraded over 30 Russian banks

It is also clear sanctions are causing significant pressures on Russian lenders, eroding their ability to service obligations in foreign currency. Fitch has so far downgraded over 30 Russian banks.

6. How likely is a Russia default and how might this play out?

The probability of a sovereign default is already high and increasing. Both Russia’s ability and willingness to pay are severely compromised due to the freezing of central bank assets and it being cut off from the global financial architecture; the severe economic impact; shortage of US dollar shortages; and retaliation against sanctions.

There is considerable uncertainty surrounding what a Russian default would mean in practice

While some companies have made coupon and principal payments, their ability and willingness to honour debts is likely to change. This is largely due to a recent decree by the government to block international-currency payments by Russian companies to creditors in 48 “unfriendly countries”. 

There is considerable uncertainty surrounding what a Russian default would mean in practice.

In a typical default, there is a well-organised restructure process and agreement among creditors. In this situation, however, the issuer is unlikely to engage with creditors. Just as critically, whether, how or where investors could make a claim are big unknowns at this point.

7. What are the key ESG implications?

Russia’s invasion of Ukraine has caused a major humanitarian crisis, with mounting casualties, significant refugee flows, and heavily disrupted access to basic goods and services. A Russian military victory is unlikely to end the bloodshed in Ukraine, with any new regime seen as illegitimate and treated with hostility in the face of likely ruthless suppression.

Sanctions on Russia will generate lasting instability, catalysing unrest and testing already frayed governance capabilities

As the crisis deepens, international concerns (particularly among western governments) are also growing, prompting escalating sanctions on Russia. By design, they will generate lasting instability, inflicting economic hardship on Russians, catalysing unrest and testing already frayed governance capabilities. 

The ESG profiles of the directly involved sovereigns have deteriorated significantly, but for different reasons. From an impact perspective, Russia’s actions have led to severely negative and worsening outcomes. Some of the main ESG implications include:

Environmental

Russia is a major global gas and oil producer with most of its exports going to Europe, creating a mutual dependency (European energy security and Russian government revenues). Gas flows to Europe, which had been reduced for months pre-invasion, have continued undisrupted – energy has so far been largely exempt from sanctions. The conflict will spur Europe to reduce its dependency on Russian fossil fuels over the coming decade.

Social

In Russia, civil liberties remain severely constrained: 1,300 people were arrested during protests shortly after the invasion. The cumulative and reinforcing impact of sanctions will create economic hardship and heighten instability, including amongst the middle classes.

Inflation is reportedly now running at 70 per cent. In the event of a Russian military victory and regime change, sanctions would very likely be expanded to cover those in Russian-controlled territories.

Food and commodity price inflation presents a challenge for the global economy

Food and commodity price inflation presents a challenge for the global economy, although higher prices will have a disproportionate significant impact on EM economies.  Consumers in poorer countries spend a far higher share of their disposable income on food than their counterparts in richer ones. Typically making up around 25 per cent of the overall spending basket, food will often be the biggest single constituent of consumer price indices.

Since history tells us rising food prices can quickly turn into a potent source of social unrest, policymakers will have to tread a fine line between acting to curb inflation and supporting consumers. ‘The Arab Spring’ uprising in 2011, with protests over food prices at its heart, provides a classic example of the challenges faced by many emerging market economies.

Governance

In Russia, Putin wields vast and near-unchecked power, with strict COVID-19 contact protocols and a reportedly small inner circle adding to his isolation – elevating (further) policy error risks. The government has tightened its already-restrictive grip over the media, with additional control over reporting, (mis)information and social media.

8. What is the likely impact elsewhere, including on other emerging markets?

The crisis has led to a surge in commodity prices, particularly for food and fuel, with oil breaking the $100 a barrel mark for the first time since 2014. Russia and Ukraine are also significant exporters of agricultural commodities, which have seen prices break through previous records.

While there are mitigating factors in maintaining global oil supply, for example through potential increased OPEC production, higher oil and food prices will add to inflationary pressures and necessitate that central banks remain hawkish despite the risks to growth from the geopolitical turmoil.

The economic growth outlook has deteriorated, perhaps reducing global GDP growth by around one per cent

The economic growth outlook has also deteriorated – estimates vary, but a consensus seems to be building with the war and the real income hit from higher energy prices (at current levels) perhaps reducing global GDP growth by around one per cent.

Of course, much depends on how high energy prices remain, and for how long. As a rough rule of thumb, every ten per cent increase in energy prices is estimated to reduce global GDP growth by around 0.15-0.2 per cent.

The damage from the Russian invasion will not be uniform. Given Europe’s dependence on Russian energy, and its closer linkages to Russian industry, the drag on the region’s growth is likely to be much greater than elsewhere.

Figure 5: Russia’s share in global commodity production (per cent)
Russia’s share in global commodity production
Source: J.P. Morgan. Data as of January 31, 2022

For emerging markets, the potential social and fiscal impact of this conflict are much greater. Food and fuel make up a relatively larger share of EM consumption baskets, and in many cases, continue to be subsidised. There is a considerable risk of increased social and financial costs, even in countries that are geographically removed from the conflict.

9. What is the impact of higher commodity prices on emerging markets?

Country level dispersion is likely to increase as investors start to differentiate between issuers better able to cope with higher commodity prices.

At a regional level:

  • Central and Eastern Europe is most exposed, both to higher food and fuel prices alongside their geographical proximity to the conflict and high dependence on Russian imports for meeting their energy needs
  • Asia: The Philippines stands out as most exposed in Asia, but also among the entire EMD universe, along with Pakistan and Sri Lanka, who are net importers of food and fuel. Mongolia stands out as a country that looks to be resilient
  • Central America contains some of the most exposed issuers globally, with the region highly dependent on food and fuel imports
  • Latin America generally looks well positioned given the number of commodity exporters, especially in metals
  • Middle East and North Africa: Oil exports aside, the region is a big net food importer. As mentioned in the article, it is also worth noting that higher food prices have often been associated with political unrest in the region
  • Sub-Saharan Africa: On aggregate, the region looks well positioned, but high debt levels and external financing requirements could pose a challenge for certain issuers
Figure 6: Most/least vulnerable issuers to higher Commodity prices (per cent of GDP)
Most/least vulnerable issuers to higher Commodity prices
For indicative purposes only not to be taken as investment advice.
Source: Aviva Investors. Data as of March 4, 2022

Figure 7 standardises and averages the commodity ‘score’ and gross external financing requirements (FX reserves). This is now a relative measure, but is a useful way to consider the two biggest risks to see weaker countries that might improve and stronger countries likely to maintain that position.

Figure 7: Gross external and commodities combined
For indicative purposes only not to be taken as investment advice. Note: Yellow = Those exposed to higher prices; Orange = Those that would benefit; Blue =  Those that should be OK.
Source: Aviva Investors. Data as of March 4, 2022

10. How has the crisis changed your view on EMD?

Although it is too early to tell if markets have reached the bottom, some of the initial panic appears to be easing. However, many questions remain in terms of how the conflict will play out from here.

Some of the initial panic appears to be easing but many questions remain

A scramble for liquidity has driven recent price movements; however, as investors begin to focus more on fundamentals and less on liquidity, opportunities will undoubtedly emerge.

Our focus is on issuers that: 

  • Stand to benefit from higher commodity prices and can take advantage of improved terms of trade
  • Those without immediate government external debt servicing concerns or where we are compensated for that risk
  • Were in a strong position going into the crisis, specifically countries without onerous gross external financing requirements or have orthodox monetary policy that can effectively ensure inflation expectations do not become unanchored

Additional factors to consider include:

  • Issuers with ready access to multilateral financing
  • Issuers at less risk of social unrest. COVID-19 has highlighted that a coherent and effective government can make a huge difference to the outcome

Effectively, our focus is on countries we believe can best weather the various facets of this conflict, and also those at or towards the end of the negative phase of their credit cycle.

Reference

  1. Russia will be marked to zero at the end of the month when it will be removed from the JP Morgan indices

Related views

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