The Unravelling of The Emerging Market

By: Uri Estrin - July 24, 2020 09:08am EST
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Emerging Markets are forced to spend on Covid and increase budget deficits that were already unsustainable and at breaking point.
Emerging Markets are forced to spend on Covid and increase budget deficits that were already unsustainable and at breaking point.

The Emerging Markets Economies (EMEs) have had a wonderful few decades of success as far as economic growth, stable currency, expanding export markets, access to debt markets and eradication of poverty goes. Africa has been touted as the world’s next engine of growth with forecasts of 6% growth spurred by a young and growing population.

Not all EMEs are the same however, with equal stages of economic development and similar levels of external indebtedness. I refer here more to traditional developing economies such as Africa, Latin America, Middle East/India and less of the middle income countries (especially in Asia) such as South Korea, Vietnam and Singapore, although many aspects are relevant to all.

Against the backdrop of Emerging Market growth, we have also seen worldwide explosion of debt. It is this explosion that has fueled the factors that have created the favorable developments in these economies.

As the hunger for debt issuance had been growing at an insatiable clip, and the Latin American debt crisis of the 1980s long forgotten, lenders have been ever more ready to issue wider and riskier in the hunt for higher yield in a world of steadily declining rates. This has given EME countries access to sovereign and multilateral developmental debt, but also to corporate debt, at unprecedented levels. Climbing debt to GDP ratios have taken decades to finally impact sovereign credit ratings with any negativity, although most sovereign bond values haven't been affected, yet.

In tandem with debt issuance, the world economy has sustained enormous growth and development requiring commodities and petroleum to fuel its frenzy. This has facilitated not only rich export earnings, but additional expansionary capital projects, financed by capital inflows, to meet a rapacious hunger for ever higher output.

Ironically, it was most likely the 1997 Asia Currency Crisis that solidified the Asian Tiger economies onto a stronger footing. Then in the Great Recession of 2008, it was the Fed’s policy of QE, together with even greater issuance of debt that sent free wheeling money to Emerging Markets in search of higher short term yield. The interest rates (and bond yields) were structurally higher and with increasing foreign currency inflows, a local currency appreciation added honey to the pot that encouraged risk-on betting. China’s POBC pushed great amounts of liquidity into its own markets and reignited an infrastructure boom of empty buildings and bridges to nowhere that kept the commodities markets humming along.

With all this money pouring in, one would think that EMEs would have address economic fundamentals, developed their educational institutions, skills and human capital, build new infrastructure to facilitate economic growth and develop new markets moving away form the Dutch Syndrome. Some did, but mostly emerging markets issued more debt on debt, and financed growing budget and trade balance deficits encouraging a population to enjoy the new fruits of middle income status that had been so easily plucked.

Debt is cyclical, growth is cyclical, commodities are cyclical. It’s admirable that billions of people have been pulled from abject poverty. But access to cheap and easy money, often by countries’ own lax fiscal discipline, created a nouveau middle class addicted to easy trappings (this by the way this isn’t only an Emerging Market phenomenon).

This has brought a sense of globalization that has spread and a sense of equalized the wealth around the world. Homes in Rio de Janeiro, Cape Town and Mexico City are as expensive as New York or Los Angeles. The well healed in those cities drive Range Rovers and Mercedes Sports cars. Restaurants are packed with expensive tasting menus and premium wines. It’s hard to imagine that an EMEs have such a prolific, in your face, showing of ostentation. There have always been wealthy people everywhere, but this is now pervasive at a new level.

But unfortunately for these markets, the cycles are turning. Even before Covid, Brazil and South Africa were downgraded to junk and Argentina is now entering it’s ninth sovereign default. Commodities are well off their peaks and falling, oil is flirting will new founds lows and it doesn’t look like roaring demand is set to pickup anytime soon.

Emerging Markets are forced to spend on Covid and increase budget deficits that were already unsustainable and at breaking point. Some would argue that rates in the advanced economies are falling and there will be a new hunt for yield. With the latest Fed QE we have seen stock markets of emerging markets hold their grounds with currencies that are surprisingly resilient. But this chase is fleeting. The risks here far outweigh the yield differentials.

As Argentina defaults (again), it is a precursor to other similarly overindebted Emerging Market nations. Three years ago Argentina was issuing 100-year bonds and it’s Peso was at 15 to the USD. Today, it’s defaulted and it’s peso is over 70 to the USD – all in a few short years. Which demonstrates the fluidity of the sentiment towards an economy.

Lebanon is a similar recent such story. As more and more countries reach their maximum level of indebtedness, we are sure to see more defaults. With new defaults, come new currency crises and a re-evaluation of risk profile. Big Emerging Market countries like Mexico (BBB-:Fitch), Turkey (BB-:Fitch), Brazil (BB-: Fitch), South Africa (BB:Fitch), Russia (BBB-:S&P) and India (BBB-:Fitch), and their parastatal proxies, should be watched with great attention and caution.

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