Pessimism was in the air at the recent IMF/World Bank meetings, with emerging markets looking vulnerable to a tightening of global financial conditions. However, their orthodox policy responses should put many countries in a stronger position to meet those challenges than previously, argue Carmen Altenkirch and Nafez Zouk.

Read this article to understand:

  • Why 2023 promises to be every bit as challenging for EM debt as this year
  • Why countries will need to keep a tight lid on public spending
  • Which countries are best placed to navigate the choppy waters ahead

Emerging market (EM) government bonds have suffered a bruising year. Investors have withdrawn a record $70 billion from mutual funds in the first nine months of 20221 as soaring interest rates in advanced economies, and a strong US dollar, pressured poorer nations’ finances.

So far this year, Sri Lanka has defaulted, joining Zambia, which defaulted in 2020. Ukraine agreed to a two-year debt standstill with creditors, Ethiopia is currently in restructuring discussions, while concerns are mounting that Ghana may be close to defaulting.  Pakistan may be pushed to default next year, particularly if its International Monetary Fund (IMF) programme goes off track. Neither more ‘orthodox’ emerging bond markets, nor those at minimal risk of default, have been spared, with yields on government bonds surging on rising inflation, tighter global financial conditions, and acute geopolitical risks.

It was against this worrying backdrop that Carmen Altenkirch (CA) and Nafez Zouk (NZ), analysts from our emerging-market debt team, recently attended the IMF’s annual meetings in Washington. They spent the week engaging with IMF and government officials, as well as other policymakers.

With the world economy expected to continue slowing, next year threatens to be just as tough for investors as 2022. The IMF stressed the importance of getting inflation back under control and keeping a tight lid on public finances.

While the atmosphere in Washington may have been subdued, the analysts’ encounters strengthened their conviction that some of the larger EM nations, such as Indonesia, Mexico and Brazil, are well placed to navigate the turbulent waters ahead. As for frontier countries, while more defaults seem almost certain, in many cases this is already reflected in bond prices.

What were the key messages to come out of the IMF meetings?

CA: I think 2023 will feel like a global recession. While a downwardly revised global growth forecast of 2.7 per cent may not appear recessionary, it would still rank as one of the worst years since the end of World War II. Multiple countries would likely see economic activity contract.

There are plenty of risks, and the triggers for a turnaround are not immediately apparent. Persistently high inflation is unlikely to fall sharply, necessitating the continuation of tight monetary policy across the globe. Despite not being globally coordinated, the effect of central banks hiking rates almost universally means the lagged effect on real activity will be felt over the coming quarters. On top of this, there are concerns the conflict in Ukraine may escalate further.

We came away from the meetings more bearish on the outlook for some markets

While we were not particularly bullish ahead of the meeting, we came away from it more bearish on the outlook for some markets, most notably Pakistan and Ghana. Both will likely need to restructure their debt over the next year, particularly if reserves continue to fall as fast as they have done this year.

In the case of Pakistan, IMF support is likely to be delayed ahead of next year’s election. But even with the Fund’s support, Pakistan might not be able to avoid default. While Ghana is also seeking support, it may have to restructure its debt first as a pre-condition for entering an IMF programme.

NZ: While the growth outlook was indeed dire, it was interesting that it was developed markets dragging the aggregate figures down. In other words, aggregate EM growth is still set to hold up relatively well, especially when compared to previous crises. The growth differential with developed countries will likely improve. That said, most EMs will still see growth rates in 2023 beneath pre-pandemic trends.

One of the key messages was that there is no room for error in the fight against inflation. The argument we heard countless times is that the cost of high inflation outweighs the costs of a recession.

Against that backdrop, there was an acknowledgement that policymakers in many mainstream EM countries had responded in textbook fashion. Central banks, for instance, identified the non-transitory nature of inflation and hiked interest rates before the likes of the Federal Reserve and European Central Bank. Those central banks have gone to lengths to maintain hawkish forward guidance.

This has given them a certain degree of policy credibility. This, together with the fact they have maintained favourable interest rate buffers relative to developed markets as the volatility and level of rates in those markets rose, gives them room for manoeuvre.

It is critical for fiscal and monetary policy to work together against inflation

Another point stressed during the meetings was that it is critical for fiscal and monetary policy to work together against inflation. Countries not only need to raise real interest rates into positive territory to tame inflation, but also need to ensure they are consolidating their fiscal accounts. Where that is not the case, market pressures can be expected.

Nevertheless, there is a recognition that even where policymakers have acted in timely fashion, these countries could potentially be at the mercy of external conditions. Almost everyone recognised the need to reduce internal and external imbalances as a priority, even if that comes at the expense of growth.

Big deficits and high debt levels are complicating efforts to respond to the cost-of-living crisis. Which nations are at most risk and what was the IMF’s policy advice?

CA: While the IMF admits a gradual and steady tightening of fiscal policy will be politically difficult, it will be less disruptive than an abrupt fiscal pullback brought on by a loss of market confidence.

Governments, most of which are strapped for cash, will need to prioritise spending. Key goals will be to ensure all people have access to affordable food and protect low-income households from rising inflation, thereby lessening the risk of a repeat of the political unrest seen in Sri Lanka and elsewhere.

NZ: According to the IMF’s latest forecasts, more countries in the emerging and frontier space will see debt decline by 2025 than will see debt rise. While this may reduce pressure for fiscal consolidation in the medium term, many EM countries still have to contend with high debt stocks, which will keep their underlying debt dynamics under close scrutiny.

There are more countries in the emerging and frontier space that will see debt decline by 2025

Countries with lower debt burdens and longer debt maturities are better placed to withstand the impact of higher interest rates, especially if they can grow their economies. However, the remaining countries will need to generate enough growth to offset rising interest costs or else will need to bring primary balances into surplus to prevent debt from rising.

Those with the highest debt amortisation needs (Figure 1) are most exposed to higher interest-rate costs (Figure 1). In frontier markets, Egypt and Ghana stand out. Brazil and Mexico also look exposed at first glance, but have some mitigating factors that leave us less concerned about their capacity to meet debt payments.

Figure 1: Most exposed to higher rates (per cent of GDP)
Most exposed to higher rates
Source: IMF. Data as of October 2022

Were there any countries you came back feeling more positive about?

NZ: Among mainstream EM countries, those who we came back more bullish on were generally the ones where monetary and fiscal policies have not been working at odds with each other. Chile and Peru are good examples.

We are more bullish on countries where monetary and fiscal policies have not been working at odds with each other

In Chile, a reduction of political uncertainty following the rejection of the constitutional amendments in September has helped improve sentiment, while an impressive fiscal adjustment this year has coincided with aggressive monetary tightening, which may now be near the end. That said, Chile’s external challenges remain acute and require close monitoring as more aggressive policy action may be needed.  While Peru is facing a high degree of political uncertainty, its fiscal and external metrics look robust.

In Europe, while Hungary is in a challenging situation, we sensed a change in tone by the authorities. They displayed a high degree of willingness to tackle the country’s external and internal imbalances through more robust fiscal and monetary policies.

CA: As for frontier nations, we are more reassured about countries that have committed to IMF programmes or whose policies closely mirror what the IMF is recommending, and which have the capacity to get through the next year without having to access the market or materially draw down reserves.

Ivory Coast and Benin fall into this category. Both have economies that are growing relatively strongly, and their governments are committed to fiscal prudence and have access to multilateral support. Costa Rica also looks to be in a better position thanks to continued IMF support.

What about China, whose economy looks to be in some difficulty?

NZ: China never strayed too far from investors’ concerns, whether with regards to geopolitics or the domestic economy. The property market slump and the economic hit from zero-COVID policies are still front and centre of discussions on China. That is leading to a debate as to whether it is facing temporary headwinds or whether its challenges are more structural. Many believe Beijing needs a new growth model given rising levels of debt and decreasing marginal returns from infrastructure investment.

There is a palpable feeling China will not be able to support global growth as it used to

Add to that a challenging geopolitical backdrop and strains in the relationship with the US, and there is a palpable feeling China will not be able to support global growth as it used to. That has implications for commodity prices, other EM countries and Asian currencies.

More countries will likely need to restructure over the coming years. Is the Common Debt Framework for Debt Treatments fit for purpose?

CA: The short answer is no. There is a significant amount of frustration from investors around the framework. The aim was to help low-income countries restructure their debt in an efficient manner by bringing all creditors to the table. However, the process is proving too complicated and slow.

It is widely agreed that the framework needs to be redesigned

Investors are also frustrated they are not being consulted early enough in the process, particularly when it comes to providing inputs into debt sustainability analysis. It is widely agreed, even by the World Bank, that the framework needs to be redesigned. Unfortunately, little real progress was made around agreeing changes. 

This is not helpful for countries in debt distress or likely to want to make use of the framework. However, while pressures are likely to build, particularly if the market remains closed, only Ghana and Pakistan are likely to default over the next year. Neither country is likely to use the framework, which should mean the restructurings proceed more smoothly. In both cases, their debt is already trading below the likely recovery value.

Climate change policies have been partly blamed for higher commodity prices. Are the costs of decarbonisation proving too high for EM countries?

CA: Recent devastating floods in Pakistan and Nigeria, and droughts in Paraguay, have once again highlighted the financial impact of climate change on some of the poorest countries in the world.

The sooner countries and companies tackle climate change the lower the ultimate impact

Some policymakers have used concern over the cost of the energy transition as an excuse to drag their heels. At the same time, higher commodity prices have raised concerns that fighting climate change could worsen the global inflation shock.

According to the IMF, the way in which policies are designed has a major influence on how they impact economic output, inflation, and the distribution of income. It argues carbon taxes should be used to reduce income tax and support investment in low-carbon technologies. The Fund believes the sooner countries and companies tackle climate change, the more gradual the response will need to be and the lower the ultimate impact.

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