Is it time to worry about an emerging market crisis?
The writer is head of emerging markets economics at Citi
Over the past two years, some have cried wolf about the risk of an impending debt crisis among low-income developing countries, but these fears deserve to be taken more seriously now.
Even before events in Ukraine introduced a new threat to global investors’ risk appetite, the double whammy of tighter U.S. monetary policy and a sharp decline in global trade growth was beginning to kick in. limit the ability of low-income countries to raise dollars. The longer the geopolitical tension remains high, the worse this problem will become.
Fears of an immediate debt crisis surfaced as soon as the pandemic hit in early 2020. The view was that many developing countries simply would not have the foreign exchange to service their debt . This kind of concern at the time was misplaced for three reasons.
First, the US Federal Reserve’s dramatic monetary policy easing has kept capital markets open to emerging market borrowers by supporting global risk appetite. Second, the huge fiscal stimulus from the US Treasury helped generate a surge in global trade. Third, the IMF has supported the financial stability of developing countries through emergency disbursements and, most importantly, through the issuance last year of $650 billion of special drawing rights, a multi-currency reserve asset.
Today, however, the external environment facing low-income developing countries is rapidly deteriorating. US monetary tightening will certainly erode investors’ risk appetite for emerging markets. The debt crises of the 1980s showed how the financial stability of developing countries is threatened when the United States has its own inflation problem to deal with.
Meanwhile, global trade growth has started to decline sharply in the latter part of 2021 – terrible news for countries that depend on such growth to generate foreign exchange earnings.
All of this is taking place against a backdrop where some important measures of developing country creditworthiness have deteriorated to worrying levels. In B-rated developing countries, for example, the average ratio of external debt to exports has effectively risen above 200 percent, a level last seen in the late 1990s. export earnings of these countries which is consumed by the service of the foreign debt has also returned above 25%, an amount also not seen for two decades.
The market had already started to worry about single B-rated sovereigns, in the sense that the last few months had seen a marked increase in their risk premiums compared to more creditworthy countries. But there is plenty of room for these concerns to deepen.
The current commodity price boom is in principle good news for low-income developing countries, many of which are commodity exporters. But this is not enough, in some cases, to compensate for the recent collapse in risk appetite.
Credit spreads in fragile commodity-importing countries have clearly widened significantly since February 24, when the invasion of Ukraine began. Yet some commodity exporters, even fragile ones, have been hurt by risk aversion.
Another reason why default risk among low-income developing countries is increasing has to do with the IMF itself. The last time developing countries suffered from some sort of systemic debt crisis, in the 1980s, the role of the IMF was more or less to keep international payments flowing. In other words, its behavior was fundamentally creditor-friendly, placing the burden of adjustment on countries themselves to control domestic spending growth by tightening their belts to service external debt.
These days, however, it makes much more sense to describe the IMF as a debtor-friendly institution. The Fund has made serious efforts to encourage the G20 to go further by offering debt relief to low-income countries under their common framework which was announced at the end of 2020. Currently, only three countries – Chad, Ethiopia and Angola – have requested debt relief in the framework and the IMF wants to get more involved. Things being what they are, the Fund can get its wish.
And since the Common Framework requires private creditors to participate on terms comparable to the G20, it looks like private creditor defaults are set to increase. This may not be a bad thing: if a country cannot pay its debt, then debt relief is entirely appropriate. And it’s worth bearing in mind that private creditors tend to have short memories, allowing a failing country to get back into international capital markets relatively quickly. But defaults are often messy – one more thing to worry about in a world full of worries.