Emerging market debt: reasons for confidence tempered with caution
With rising US interest rates and the US-China trade war intensifying, 2018 was a volatile year for emerging markets (EM). The US dollar’s strength led to broad-based EM currency depreciation, aggravated by currency crises in Turkey and Argentina. In this article we examine the prospects for EM debt in 2019.
Letters between Beijing and Washington
Examining fundamentals, there are reasons for optimism. A few countries aside, debt is not at levels that would present systematic risks. Furthermore, the superior growth rates of EM countries provide a tailwind for the asset class. True, short-term growth is likely to remain soft. However, the differential over developed markets should increase as the year progresses. As a result, capital flows into EM are set to improve.
The US growth cycle is also important. We expect the US economy to moderate but avoid a recession. Meanwhile, the US Federal Reserve (Fed) is responding to the changing environment. It shocked markets on 30 January by putting interest rate rises on hold. Investors were expecting two increases this year. No longer. The Fed also said it would be “flexible” when it came to reducing its balance sheet. EM currencies climbed in response.
The Fed’s surprise decision to put interest rate rises on hold is positive for many emerging markets.
Another potential catalyst is China. In addition to US tariffs taking effect, China’s economy is slowing. GDP grew 6.6% in 2018 – the weakest pace in 28 years. But Beijing has considerable monetary and fiscal firepower at its disposal (Chart 1). Policymakers are already improving corporate access to credit. Issuance of municipal bonds to fund infrastructure investments has been rising. Should these measures prove insufficient, we can expect further monetary easing. We could also see more local-government bond issuance. A cut in corporate taxes is another possibility. That said, the positive impact on EM debt markets is likely to be smaller than the massive infrastructure-related stimulus measures of 2009 and 2015/16 – but it could still be considerable.
Chart 1: Room for easing
Source: China Bureau of Statistics, Haver, Aberdeen Standard Investments (as of November 2018)
Against these positives, there are risks. The most obvious danger is an intensification of the US-China trade war. However, the temporary ceasefire agreed at the G20 summit in Argentina was positive. Recent comments have also been encouraging. President Trump struck a bullish note ahead of his State of the Union address. He said talks were “doing very well” and that there is a “good chance” on a deal of tariffs. With China’s economy slowing, Beijing may also been keen to reach agreement.
Either way, an escalation in hostilities is already in the price. A resolution to the conflict would therefore significantly boost sentiment towards EM.
Elections on the horizon
Politics also present risks. However, these are likely to be more country-specific than the consequences from 2018 Mexico and Brazil elections. In Argentina, President Macri is currently level in opinion polls with populist former president Kirchner. Macri’s hope is that the economy will recover in time for October’s election, but this might be too optimistic. A Kirchner win poses its own problems. In the past, she has been critical towards the International Monetary Fund (IMF). This could make cooperation on much-needed reforms a distant prospect.
In South Africa, the ruling African National Congress is certain to retain its parliamentary majority. However, the margin of victory might change the balance of power between President Ramaphosa and his party rivals. And it is here where problems arise. The country’s credit rating has been on a downward trajectory over the past few years. Changing this will require decisive policy action – which will be difficult to achieve with a weakened president. Meanwhile, India’s ruling party has been pressing ahead with essential reforms. But further progress will depend on it retaining its position in the 2019 general elections. Recent defeats in state elections suggest that this is far from certain.
Ukraine is a special case. Its debt sustainability remains questionable. However, the country has been in an IMF programme. This has helped it implement important structural reforms and regain market access. However, March’s presidential election could imperil this. Former Prime Minister Tymoshenko currently has a significant lead in the polls on a populist programme. Given rising tensions with Russia, Ukraine also represents a potential geopolitical flashpoint.
Finally, there’s oil. Despite weakness in 2018, the oil price is still higher than the assumptions baked into most EM budgets. But a weaker oil price is likely to benefit local-currency debt markets rather than hard-currency ones. That’s because oil importers – including India and many other Asian countries – make up a higher proportion of local-currency benchmarks than oil exporters, who have a greater share of the hard-currency indices. As such, there are opportunities as well as risks here.
Overall, 2019’s risks appear largely country-specific. The potential catalysts for positive performance, however, are broader-based. Meanwhile, prices already reflect the systematic risks, such as a step-up in the US-China trade war. So, we view 2019 with some confidence, albeit tempered with caution.