Following a series of IMF meetings in Washington, D.C., Carmen Altenkirch and Dariusz Kedziora discuss their views on how reform prospects may shape emerging market debt.
4 minute read
Emerging market countries are facing increasing challenges as global economic growth is moderating while political uncertainty is rising, making structural reforms more important to attract capital and help sustain economic growth. Yet the pace of progress may be slowing.
According to the International Monetary Fund (IMF), emerging markets need to deepen reforms in six target areas to protect their economies in a more fragile environment: governance; trade; labour; domestic finance such as interest rate controls; external finance; and market regulations, including property rights.1
Emerging markets need to deepen reforms in six target areas to protect their economies in a more fragile environment
The success of reforms will depend on a range of factors, such as timing, implementation, how dependent a country’s economy is on external capital, and how the reforms themselves interact with the existing institutional infrastructure. Among these, one of the most important is the alignment between the goals of politicians, policymakers and the public – the greater the alignment, the higher the likelihood of success.
Following key elections in many emerging markets in the past year, new voter mandates offer opportunities for a renewed push to enact reforms. Ukraine is a case in point where an election helped to align goals. President Volodymyr Zelenzky’s resounding victory in April was a popular vote against corruption and in favour of reform.
Ukraine is a case in point where an election helped to align goals
Indeed, Zelensky’s reform plan shows early signs of progress, with a new IMF programme likely to be signed in the coming months. Improved domestic confidence is boosting growth, which is expected to pick up to 3.3 per cent in 2019 from 2.5 per cent in 2017. Improved confidence is supporting significant inflows into the local market to the tune of US$4 billion so far this year, helping the hryvnia end the year as among the best performing emerging market currencies. A stronger currency lowered inflation, enabling the nation’s central bank to cut interest rates to encourage economic activity.
The government must show it is serious about fighting corruption and recovering billions of dollars
However, more needs to be done. To maintain this trajectory, Zelensky should address concerns around corruption and central bank independence, loosen rules on land ownership, introduce anti-monopoly policies and stabilise the legal system. IMF negotiations have also hit an early snag linked to the nationalised PrivatBank. A government decision to nationalise PrivatBank in 2016 is being challenged by Ihor Kolomoisky, a business tycoon with ties to Zelensky.2
The government must show it is serious about fighting corruption and recovering billions of dollars pumped into PrivatBank. If reforms materialise and investors are reassured, Ukraine could benefit further from a growth rebound.
A longer road to reform
Economic reforms can benefit all countries but may be a higher priority for smaller emerging markets, which are often more dependent on external funding. Yet they are more vulnerable to external shocks, such as lower commodity prices and adverse market sentiment. In this way, there is less ability to recover from policy mistakes.
Angola has demonstrated strong commitment to reform but is starting from a more vulnerable position compared to Ukraine
Angola has demonstrated a strong commitment to reform but is starting from a more vulnerable position compared to Ukraine. In Angola, new president João Lourenço unpegged the country’s currency, the kwanza, to make the country more attractive to investors. However, volatility spiked as a result, and the kwanza has been one of the worst-performing currencies this year. Lourenço’s priorities include stabilising the exchange rate, strengthening foreign currency reserves and implementing measures to reduce the government’s financing needs.
Zambia also faces significant challenges and may lack the political will to push ahead with IMF-led reforms
Zambia also faces significant challenges and may lack the political will to push ahead with IMF-led reforms. While some policymakers are seeking IMF support and would like to move ahead with fiscal consolidation, President Edgar Lungu is increasing spending, particularly on infrastructure, in a bid to win votes ahead of the 2021 election. A debt maturity wall is building, with no agreement to renegotiate with Chinese authorities, Zambia’s largest creditor. External borrowing is rising, but foreign exchange reserves are running low, risking a debt crisis.
Both countries are heavily reliant on commodities – oil in the case of Angola and copper in Zambia. At a time when oil may be in a structural decline and volatility in metals is rising, reforms are all the more necessary yet there is no certainty they will be effective.
Alignment of interests
Structural reforms can take longer than expected to deliver. If they are also aligned with the support of local businesses, policymakers and the general population, they will more likely to yield long-term results. Consider Brazil, for example, where difficult pension reforms proposed by newly-elected President Jair Bolsonaro were approved by the Federal Senate on October 22 with the support of political leaders, technocrats and voters. The initiative injected a much-needed dose of investor confidence. The value of the Brazil five-year credit default swap (CDS), the cost of insuring against default and a measure of the risk premium, fell to 121 bps as at December 5 from about 210 bps at the start of the year, see Figure 1.
Alignment is important, considering Chile, where a wave of violent protests that began over subway fare hikes in October is disrupting the economy
We can also see how important alignment is by considering Chile, where a wave of violent protests that began over subway fare hikes in October is disrupting the economy. For decades, the country had been regarded as a poster child of market-friendly reforms, attracting foreign capital and improving overall income levels. Yet these policies also resulted in massive wealth inequalities within Chile, helping to fuel the recent protests and putting pressure on its economy. While Chile’s five-year CDS remains far below Brazil’s, it rose to over 50 bps as at December 5 from about 30 bps prior to the protests, see Figure 1.
Figure 1: Five-year CDS: Brazil vs. Chile
Brazil also suffered from mass demonstrations in 2015 and 2016 following a corruption scandal. But this time around, Bolsonaro was able to push through a painful national pension overhaul without widespread public unrest. When it comes to reforms, timing helps.
The strength of existing institutional infrastructure also can contribute to the impact of reforms, with governance among the most important component according to the IMF.3 Improvements in governance not only directly supports more productive economic growth, but indirectly magnifies the impact of new, unrelated reforms.
Poland has undertaken 30 years of structural reforms and is Europe’s fastest growing economy
Poland, for example, has undertaken 30 years of structural reforms. The main policy trajectory has been consistent and received public support. After Poland joined European Union in 2004, it benefitted from the reforms from the prior years, allowing the country to take full advantage of new opportunities and unprecedented growth. Poland’s GDP per capita has increased by almost 150 per cent since 1989, making it Europe’s fastest growing economy during this period.4 The country is one of the best examples of what aligned reforms can accomplish over time.
Poland’s attempt to restrict judicial oversight could also undermine their governance infrastructure and scare off potential investors
However, a recent law that severely tests judicial independence is raising concerns internationally. The government has introduced legislation to hold that judges can be investigated and sanctioned for their court rulings. The law is being contested in Europe’s highest court by the European Commission. The country’s attempt to restrict judicial oversight could also undermine Poland’s governance infrastructure and scare off potential investors.
Addressing problems in isolation without considering how they might impact other parts of the economy may offset any benefits. For example, if a country eases rules to encourage foreign investment yet fails to protect investor rights, any positive impact is likely to be minimal. The reverse is also true. If countries simultaneously address all six areas of reforms identified by the IMF, GDP could rise by at least one percentage point annually over a six-year period.5
At the same time, reforms have to be shaped by the unique circumstances of each country. Success is only possible when goals are aligned, both internally and externally.