News in Charts: Emerging risk to emerging markets

The global economy is set to grow strongly in 2021 amid a rebound in developed markets (DMs) led by the US. This should provide a helpful boost to exports from emerging markets (EMs). The IMF forecasts real GDP growth of 6.7% for EMs in 2021 and 5% in 2022, after a contraction of -2.2% in 2020. There are, however, six major risks which could affect EMs to varying degrees over coming quarters. In this research note we will use our Fathom Financial Vulnerability Indicator (FVI), which gauges the likelihood of sovereign, banking or currency crises in 176 countries, to help assess these risks.

Risks of Taper Tantrum II: As prospects for the US economy have significantly strengthened amid the passing of a $1.9 trillion stimulus package, US Treasury yields have risen by around 70 basis points since the start of the year. The increasing attractiveness of American assets has weighed on capital flows to EMs and fuelled a depreciation of many currencies. There is a significant risk that as the US economic recovery accelerates over coming quarters, or if there is an unwelcome surge in inflation, there could be a further sharp spike in Treasury yields. This could fuel a repeat of the 2013 Taper Tantrum – where there was a violent sell-off in EM assets and sharp declines in their currencies. Even without a messy market tantrum, further rises in US yields will raise EM borrowing costs and reduce liquidity. These are likely to fuel additional weakness in EM currencies against the USD, which could lead to undesirable increases in inflation.

Risks from further COVID-19 surges: New COVID-19 cases have fallen sharply across many countries and regions since the end of last year, although this is not the case for all countries. India in particular has suffered a resurgence of cases linked to a new variant. There have also been quite wide divergences in the speed of vaccination programmes. Despite some outliers, most EMs are typically significantly behind their developed peers and it seems likely that this will continue. Hence, they will be at greater risk of further damaging surges until they have fully vaccinated their populations or reached sufficient herd immunity. The Covax programme, which has been set up to provide vaccines to the poorest developing countries, will only guarantee to vaccinate up to 20% of each population and has been falling short of its targets. Those countries highly dependent on international tourism will remain particularly at risk. In the short term, we would expect investors to withdraw funds from economies that experience surges in COVID cases. In the longer term, economies that take longer to recover from the pandemic are likely to accumulate larger imbalances.

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Commodity prices: Global commodity prices have risen sharply as confidence has increased in a global economic recovery. Oil prices of $64 per barrel are up 31% since the start of the year, while industrial metals and ‘agricultural & livestock’ prices are around their highest levels since 2011 and 2012 respectively. For EMs, food prices typically constitute a much higher share of the Consumer Price Index (CPI) basket than in DMs. Higher commodity prices can negatively affect EMs by pushing inflation above central bank targets, which may mean central banks have to tighten policy even if domestic economic conditions may not warrant it. There is, however, a clear split in EMs between large commodity exporters and large commodity importers. The former benefit from stronger exports, investment, and fiscal and current account balances when commodity prices rise (and often from appreciating currencies, amid improved terms of trade). In contrast, commodity importers experience a fall in real incomes and deteriorating fiscal and current account positions, which can make any pro-cyclical policy tightening due to higher commodity prices particularly problematic.

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Political economy risks: Always front and centre in EMs, political economy risks could intensify. High unemployment and elevated government debt levels could fuel a rise in populism and/or encourage governments to embrace increasingly populist policies. This would clearly unnerve business confidence and foreign investors. Recent attempts by the Colombian government to improve the public finances through tax rises fuelled major street protests. The government ultimately relented, although Standard & Poor’s has subsequently cut the country’s credit rating to junk status. In Chile, the government and other establishment parties performed badly in the recent election of delegates to draft a new constitution. As a result, fears of a populist shift fuelled a sharp decline in the stock market.

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Unsustainable debt and imbalances could build: Many EMs saw large increases in their debt levels over the previous decade (chart below). The pandemic has severely exacerbated these problems amid massive increases in government debt, which on 2021 IMF forecasts will be over 80% of GDP in South Africa, around 90% of GDP in Egypt, India and Pakistan and around 100% in Brazil. Assuming US inflation does not rise to unwelcome levels, as some fear, and adept communication allows US monetary policy to remain extremely accommodative for the foreseeable future, very easy global financial conditions could dissuade many governments from taking the difficult decisions necessary to improve their fiscal positions. Authorities in some countries may even encourage a further build-up of private sector debt, in order to boost growth and prevent a further deterioration in the government finances.

Unfortunately, this may mean that when the Fed does eventually begin reducing its QE and raising interest rates there could be an extremely difficult adjustment for many EMs, with the risk of a repeat of the crises seen in the 1980s and 1990s. Even without a normalisation of Fed policy, growing imbalances will make countries increasingly vulnerable to shifts in investor risk appetite — caused either by domestic events or external shocks.

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Exposure to US/China relations: Geopolitical competition between the US and China has intensified over recent years and shows no signs of abating. This could present both opportunities and risks for various EMs. Over time, some fear that the world could split into two camps, of those allied to the US and those more friendly to China. Clearly, a further escalation in tensions between two major global economies would be harmful for business and investor confidence globally. It could cause particular difficulties for EMs allied with the US but for which China is the major trade partner. That said, China acts primarily as the intermediary in the Indo-Pacific supply chain, with the US as the ultimate source of demand. This may mean that restructuring of supply chains over time could lessen the importance of the Chinese market to some countries.

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