A recent trip to Central America and the Caribbean revealed much about the attractions and pitfalls of frontier markets, explains Aaron Grehan.
3 minute read
Investing in frontier markets*, which are smaller and less liquid than established emerging markets, is not for the faint of heart. While the prospect of rapid growth is an obvious allure, understanding and monitoring the complex political issues that mould each country’s outlook is critical, as I discovered during a recent visit to Costa Rica, El Salvador and the Dominican Republic.
All three countries share a Spanish colonial heritage; are similarly endowed in terms of natural resources; and have relatively small populations.
Costa Rica, the most economically advanced with GDP per capita almost three times that of El Salvador, has enjoyed political stability and economic prosperity since a 44-day civil war in 1948. That led to the dissolution of the army, with military spending diverted into education.
The Dominican Republic, with GDP per capita around half of Costa Rica, has a tumultuous history but has been largely peaceful for the past 20 years, with governments generally following pragmatic and pro-business policies.
Meanwhile, El Salvador is a still-fragile democracy that bears the economic and political scars of the 12-year civil war that ended in 1992.
Cautious optimism over Costa Rica
Costa Rica has much to admire. A welleducated population – the constitution requires a minimum eight per cent of GDP to be spent on education – has helped create a flourishing service sector, as well as a value-add manufacturing industry. Annual GDP growth has averaged four per cent for the past decade, while foreign direct investment flows have averaged 7.5 per cent of GDP per annum since 2005.1
However, a lack of political cohesion has led to credit deterioration in recent years. Public sector debt has risen from 24 per cent of GDP in 2008 to nearly 50 per cent today; reflecting a deep, structural fiscal deficit that has remained unaddressed for years. Any adjustment is difficult given 95 per cent of expenditure is mandatory.2 A fiscal adjustment of between 3.5 and four per cent is required to stabilise the debt, but an adjustment of only half that level can realistically be expected.
Presidential and congressional elections will take place in 2018. While it seems unlikely measures to address the deficit will be passed before the elections, finance ministry officials have warned that politicians need to act quickly before the situation becomes unsustainable.
Despite concerns over the deficit, stateowned entities in Costa Rica appear attractive given government guarantees and strong local investor participation. Long-dated government bonds also present opportunities given the steepness of the yield curve.
Dominican Republic: the safe bet?
The Dominican Republic has been a bright star in the frontier markets universe for some time. Unlike El Salvador and Costa Rica, the country benefits from a supportive political environment. The Partido de la Liberación Dominicana (PLD) has large majorities in both houses and President Danilo Medina was re-elected for a four-year term in 2016.
Growth is expected to reach over five per cent in 2017, according to the International Monetary Fund (IMF). Foreign direct investment, mainly channelled to tourism (which generated $25 billion in 2016) and increasingly mining, is sufficient to comfortably cover the current account deficit of around three per cent of GDP. Meanwhile, a well-capitalised banking sector helps maintain financial stability.3
The construction of Punta Catalina, a coal-based electricity plant due to come online in 2018, will lower the country’s dependency on oil and gas. By reducing transfers from central government to electricity companies, it should also boost public finances.4
The government is considering alternative financing for the project, which could result in lower debt issuance, a development that should support bond prices.
Risks worth watching include the rivalry between two main factions in the PLD and any further fallout from an ongoing corruption scandal. Around a dozen people, including current and former top officials, were arrested in May in relation to $92 million in bribes paid by the Brazilian construction company Odebrecht to obtain public works contracts in the country.
A political analyst warned me there is a danger the PLD, having enjoyed three consecutive terms, could lack the will to press ahead with further reforms.
On balance, however, the Dominican Republic continues to appeal to investors given its positive mix of economic fundamentals and attractive yields.
Political pact key to El Salvador’s prospects
The political environment in El Salvador remains polarised. A former rebel leader, Salvador Sánchez Cerén, won the 2014 presidential election by a tiny margin over the right-wing ARENA party candidate. Ceren’s left-wing Farabundo Marti Liberation Front had previously emerged as the largest party in parliamentary elections.5
A lack of trust between the main parties, internal party divisions and ideological differences are frustrating attempts to resolve fiscal and financing issues caused by an unsustainable pension system. Certainly, El Salvador faces the greatest challenges of the three countries I visited.
The government missed a payment to a local pension fund in April, due to a political stalemate in Congress that prevented the passage of a key finance bill. The default led to credit-rating downgrades by both Moody’s Investors Service and Standard & Poor’s.
The political standoff, exacerbated by legislative elections next year as the parties jockey for support, threatens a potential IMF deal that would provide both much needed financing and policy discipline to correct the fiscal issues.
I learned that high-level negotiations between the main parties, brokered by an international agency, are underway to find a way forward on improving the fiscal position. The willingness of the parties to participate is encouraging and likely stems from the negative external reaction to the recent default, which they had underestimated.
A positive outcome from these discussions could cause spreads to tighten. However, recent developments highlight the extent of the political divide. The parties are currently at loggerheads over pension reform. Without an agreement, the government’s fiscal position will become even more challenging next year.
* Frontier markets are smaller, sub-investment grade and less accessible than larger emerging markets. To be eligible for inclusion in JP Morgan’s Next Generation Markets Index (NEXGEM) – a subset of its Emerging Markets Bond Index Global (EMBIG) – the country must have a rating of Ba1/BB+ or lower from Moody’s and S&P, and cannot be a European Union member or be in the process of seeking EU membership.
1 Costa Rica: 2017 article IV consultation, IMF, June 2017
3 Dominican Republic: 2017 article IV consultation, IMF, August 2017
4 ‘Moody’s upgrades Dominican Republic’s issuer rating to Ba3 from B1, outlook stable,’ Moody’s press release, June 2017
5 ‘El Salvador’s new president faces gangs, poverty and instability,’ National Public Radio, March 2014