While uncertainty around the US rate-hiking cycle is affecting appetite for emerging-market debt, discerning investors can still find attractive opportunities in 2023, say Aaron Grehan and Carmen Altenkirch.
Read this article to understand:
- Our expectations for EMD issuance in 2023
- How China’s reopening could affect EMD
- Which EM sovereign issuers look resilient, and which are more vulnerable
Emerging economies suffered in the wake of Russia’s invasion of Ukraine, as inflation spiked and their citizens struggled to make ends meet. Central banks around the world, including the Federal Reserve, hiked interest rates to tackle rising prices; this led to a strengthening in the dollar and prompted capital outflows, putting developing countries under pressure.
Overall, however, emerging markets have proved more resilient than during previous downturns, with many sovereign and corporate issuers still boasting stronger credit metrics than their developed-market counterparts.1 And emerging-market prospects should receive a further boost thanks to the reopening of the Chinese economy, following Beijing’s abrupt reversal of its strict zero-COVID policy.
After market jitters early in 2022, rising yields tempted investors back to EMD towards the end of the year; many higher-rated countries took advantage of this by issuing debt in January and February, covering immediate financing needs. But while the outlook is broadly positive and all-in yields continue to look attractive, investors should stay vigilant. With inflation proving sticky, the war in Ukraine grinding on and US-China relations plumbing new depths following a spat over surveillance balloons, geopolitics could yet derail the recovery.
In this Q&A, Aaron Grehan (AG), head of hard-currency emerging-market debt, and Carmen Altenkirch (CA), EM sovereign analyst, pick out the key themes to watch over the coming months.
What have been the key developments in EMD so far this year?
AG: We have seen a shift in sentiment: uncertainty around the Federal Reserve monetary tightening cycle has started to affect investor perceptions of EMD. Strong US consumer and employment data, along with stickier-than-expected inflation, have led to speculation the Fed tightening cycle may have some way to run.
But while we are likely to end up with a slightly higher terminal interest rate than expected at the beginning of the year, our view remains that fixed-income investments are likely to deliver attractive returns in 2023, with EMD likely among the better performers. Growth prospects and debt metrics still look attractive relative to developed-market sovereigns [see Figure 1], but there is significant dispersion and investors should be discerning in their choice of securities.
CA: Issuance has been much stronger than might have been expected, particularly for investment-grade credits. At the start of the year, countries in central Europe and elsewhere took advantage of inflows into the market to bring forward issuance plans in hard and local currencies. For a large part of the investment-grade universe, financing requirements are largely met, and there will be less of a need to come to market later in the year.
By contrast, most high-yield issuers remain shut out, although Egypt was able to raise $1.5 billion with a sukuk [a form of Sharia-compliant debt security] in late February with a yield in excess of ten per cent. Issuing at a cost of over ten per cent is generally a sign of desperation. The countries that faced financing and liquidity challenges last year still look vulnerable.
Figure 1: Differentiation and dispersion, EM versus DM
Source: Aviva Investors, IMF. Data as of January 2023
How are EM central banks addressing the current environment?
AG: They are facing the same issues as developed-market central banks. The European Central Bank, South African Reserve Bank and Bank of Mexico are all grappling with inflation.
Generally, however, EM central banks were faster in raising interest rates so are under less pressure to quicken the pace of tightening. Many emerging markets need and want to loosen policy before high rates become a constraint on growth, but that is difficult because of rate hikes in developed markets.
The cost of financing is becoming an issue, not just for high-yield issuers but also some larger local-currency issuers
The cost of financing is becoming an issue, not just for high-yield issuers but also some larger local-currency issuers. Colombia, for example, recently had to auction bonds with a coupon of 13.5 per cent; in Mexico, the next local-currency issue is likely to nudge ten per cent. These are very elevated financing costs.
CA: In addition to financing costs, smaller emerging-market economies must also think about the implications for foreign exchange reserves. Not only is inflation a lot higher in these countries, but their capacity to reduce rates is constrained by the need to prevent FX reserves from falling further. They end up being forced to keep interest rates higher than they would like.
What are the implications of China’s reopening?
AG: There is uncertainty around the precise composition of China’s economic growth during the current rebound. If it is primarily consumer-led, similar to what we’ve seen post-COVID in the developed world, the impact on wider emerging markets might be limited. But if we also see a recovery in the property sector, along with a resumption in infrastructure investment, that might be more consequential for other EM countries. The data is not yet clear.
Most emerging markets have faced COVID-related challenges with production in recent years
In any case, China is just one part of the picture. Most emerging markets have faced COVID-related challenges with production in recent years, which has affected exports of oil, metals and other resources. Those won’t be fixed simply because China is growing faster. EMD investors always need to look beyond the macro picture to take country-specific factors into account.
CA: Unless we see signs Chinese growth is more investment-led, and therefore supportive for a broader spectrum of commodities, the prospects for countries like Ghana and Nigeria remain unchanged. These nations don’t just need higher commodity prices, but an outright increase in demand to see any substantial difference to their outlook.
Where are we looking for opportunities in hard-currency EM sovereign debt?
AG: We see lots of opportunities among high-yield sovereigns, but there is a need to remain selective given the macroeconomic uncertainties. Our focus is on countries with a stable outlook, where we see the potential to earn elevated yields without too much volatility.
The most resilient high-yield issuers retain access either to primary bond markets or multilateral financing
CA: We group high-yield issuers into three main categories. The first comprises “resilient” high yield: this includes countries that have come out of the multiple crises of recent years in reasonably decent shape, reflecting good policymaking, decent economic growth and manageable debt and budget deficits. But probably the most important characteristic these countries share is that they retain access either to primary bond markets or multilateral financing. Examples would include Costa Rica, Dominican Republic, Ivory Coast and Senegal.
The next category includes credits in default or near distress, but where pricing is at a level that provides adequate compensation for the risk. We need to have a reasonable degree of comfort that a country, once it has gone through its restructuring process, will be back on a sustainable footing; the prerequisite is a high-functioning government committed to consolidating public finances in future. Ghana is the best example.
In the third category are issuers to avoid, because the market underappreciates the risk of default or extreme distress. Often, emerging-market investors focus too much on pure solvency metrics and a country’s ability to meet its debt-servicing requirements, without putting enough emphasis on near-term liquidity risks. Pakistan is in this group (see Figure 2).
Figure 2: Assessing debt distress: Solvency and liquidity risks
Source: Aviva Investors, IMF. Data as of January 2023
The International Monetary Fund is in discussions with Egypt and Pakistan, but its debt sustainability analysis (DSA) framework is set up to deal with solvency and structural liquidity challenges, not near-term liquidity challenges. What does that mean for countries at high risk of default?
CA: The DSA framework was designed to solve solvency issues, i.e., too-high debt-to-GDP ratios or structural liquidity issues, either because the country does not generate enough exports (dollars) or because its debt-service payments were unsustainable. In the past, balance of payments or liquidity issues were dealt with via IMF programmes.
A lot of countries have reached the limits they can borrow from the IMF
The problem is that a lot of countries have reached the limits they can borrow from the IMF, or the conditions the IMF is imposing are too severe given the more-challenged political backdrop many issuers face.
Egypt and Pakistan are in this group. Egypt recently agreed an IMF programme, but the net financing it was able to access was negative; Egypt will be a net re-payer of funds to the IMF over the course of the programme. In the case of Pakistan, the IMF is being stringent due to concerns about debt sustainability. There is a high risk these countries are forced into restructuring. This is not necessarily because they have solvency or structural liquidity concerns, but because they will run out of dollars and the IMF is no longer willing to provide cash like it would have done previously.
How is the war in Ukraine affecting the outlook?
CA: Of the 16 countries with a negative average credit outlook – which means two of the three main rating agencies have them on negative watch – the greatest concentration is in Eastern Europe, including highly rated issuers such as Latvia, Lithuania and Estonia, and lower-rated sovereigns such as Romania and Hungary. This is largely a function of the negative economic spill overs from the Russia-Ukraine conflict.
Other countries with negative outlooks include Panama and Peru, in part a reflection of recent social protests and rating agencies’ expectations about what that will do to the outlook for public finances in those countries.
Given persistent inflation and cost-of-living pressures, are you concerned social unrest could spread across emerging markets?
CA: Since inflation spiked in the wake of Russia’s invasion of Ukraine, many EM governments have been willing, if not always financially able, to offer subsidies for fuel and food, which has assuaged discontent and resulted in fewer protests than one would have anticipated. That said, EM spending on subsidies has contributed to elevated fiscal deficits. The question is, in the event of another shock, what fiscal space do countries have to continue with subsidies? If subsidies are withdrawn, social unrest could spike again.
Following COVID-19 and the Russia-Ukraine war, credit metrics have deteriorated
AG: That speaks to a wider point around the fiscal buffers countries have to withstand further external shocks. Following COVID-19 and the Russia-Ukraine war, credit metrics have deteriorated. These shocks have made economies across the world more vulnerable, and EM has not been spared.
Look at what is happening in Pakistan, which is still reeling from the floods that hit in 2022, or Turkey, which now must rebuild following the devastating earthquake in February. These countries’ ability to deal with such events is much more constrained than it would have been absent the crises of the last two years.
G20 finance ministers met in February to discuss the debt restructuring process for vulnerable countries, but without resolving their differences.2 Does this impact your outlook for high-yield sovereigns?
CA: In the past, debt restructurings have largely taken place between Western multilateral/bilateral creditors – the likes of the IMF, the World Bank, Paris Club and others – and Eurobond holders. In part, what the G20 Common Framework attempted to do was to bring in all creditors to work on debt restructuring.
China and India have become major creditors for EM countries
Over the past decade, China – and, to a lesser extent, India – have become major creditors for EM countries. The challenge is that incorporating China into these discussions takes time. Take Zambia: one of the reasons debt negotiations with that country have taken so long is that China prefers to increase the maturity structure of its debt rather than take haircuts, which is at odds with what multilaterals or Eurobond holders see as a preferable outcome.
The broader point is that for high yield to attract new money, we need to see debt restructurings happen much more quickly and efficiently. A prolonged process has a direct economic impact on the country involved and is a disincentive to future investment.
EM corporate debt has shown notable resilience in the face of recent turbulence.3 Which sectors look attractive in the current environment?
AG: EM corporate debt still looks resilient. The major development since last year is the improved growth outlook in China, which should boost Chinese state-owned companies and firms in neighbouring countries such as Thailand and Indonesia, whose economies are likely to see stronger growth thanks to greater Chinese activity. That should feed through into the corporate sector.
There is much debate on how development banks can offer more blended finance to help de-risk investments in climate transition and adaptation projects. What are your views on these mechanisms, and on green, social and sustainability-linked bonds more broadly?
AG: Climate transition plans have been complicated by the immediate financial pressures countries face. South Africa is a good example; the country must transition away from coal, but at present it faces energy shortages and blackouts. The priority is making sure state-owned energy companies can function and provide power.
While we see increasing green-bond issuance from EM sovereigns, particularly in the Middle East, it is rarely at a scale that would deliver real change; more often, it is simply fulfilling a new debt structure for investors.
It is surprising we haven't seen more blended-finance structures to help countries
CA: One of the things that has surprised me post-COVID and Russia-Ukraine is that we haven't seen more blended-finance structures to help countries, either with the resolution of ongoing debt challenges or their green transitions. There are some funds administered by the likes of the World Bank that aim to support countries using blended finance, but the amount of financing dispersed through these facilities is very small.
Take the IMF’s Resilience and Sustainability Facility (RSF), aimed at providing financing for the green transition. The requirements to access RSF funding are extremely difficult to meet; only institutionally strong sovereigns on the higher end of the high-yield spectrum, such as Costa Rica, Ivory Coast and Senegal, have the requisite capacity. The RSF isn't providing financing for the likes of Nigeria or Angola, which have much larger carbon footprints and greater need to diversify away from hydrocarbons.
This is a microcosm of sovereign issuance more generally: better credits have better access to high-quality and more-affordable financing, which enables them to remain better credits. Similarly, countries that have a climate transition framework are likely to be institutionally stronger and in a better position to access financing, which enables them to accelerate transition plans.