Is it time to worry about an emerging markets crisis?

The writer is head of emerging markets economics at Citi

The past two years have seen some crying wolf about the risk of an imminent debt crisis among lower-income developing countries, but those fears are worth taking more seriously now.

Even before events in Ukraine introduced a new threat to risk appetite among global investors, a double whammy of tighter US monetary policy and a sharp decline in global trade growth was beginning to constrain the ability of lower-income countries to get hold of dollars. The longer geopolitical tension stays elevated, the deeper that problem will become.

Fears of an immediate debt crisis surfaced as soon as the pandemic did in early 2020. The view was that many developing countries simply would not have the foreign exchange to service their debt. That kind of worry back then was misplaced for three reasons.

First, the US Federal Reserve’s dramatic loosening of monetary policy kept capital markets open for emerging markets borrowers by supporting risk appetite globally. Second, the US Treasury’s huge fiscal stimulus helped to generate a surge in global trade. Third, the IMF supported developing countries’ financial stability through emergency disbursements and, above all, through the issuance last year of $650bn worth of special drawing rights, a multicurrency reserve asset.

Now though, the external environment facing low-income developing countries is deteriorating fast. US monetary tightening will certainly erode investors’ risk appetite towards emerging markets. The debt crises of the 1980s showed how the financial stability of developing countries is threatened when the US has an inflation problem of its own to deal with.

Meanwhile, global trade growth started to decline sharply in the latter part of 2021 — terrible news for countries that depend on such growth to generate foreign exchange revenues.

This is all taking place against a background in which some important metrics of developing countries’ creditworthiness have deteriorated to worrying levels. In developing countries rated single B, for example, the average ratio of external debt to exports is effectively back above 200 per cent, a level last seen in the late 1990s. Equally, the amount of these countries’ export revenues that is consumed by servicing external debt payments is also back above 25 per cent, an amount also not seen for two decades.

The market had already begun to worry about single B-rated sovereigns, in the sense that the past few months had seen a marked increase in their risk premia relative to more creditworthy countries. But there is plenty of space for these concerns to deepen.

The current surge in commodity prices is in principle good news for lower-income developing countries, many of whom are commodity exporters. But it is not enough, in some cases, to offset the recent collapse in risk appetite.

Credit spreads for fragile commodity importing countries have obviously widened markedly since February 24, the start of the invasion of Ukraine. Yet there are also even some fragile commodity exporters which have been hit by the risk aversion.

Another reason why default-risk among low-income developing countries is rising has to do with the IMF itself. The last time developing countries suffered something like a systemic debt crisis, in the 1980s, the IMF’s view of its role was more or less to maintain the flow of international payments. Its behaviour, in other words, was basically creditor-friendly, putting the burden of adjustment on countries themselves to control domestic spending growth through belt-tightening in order to service external debt.

These days, though, it is much more sensible to describe the IMF as a debtor-friendly institution. The Fund has been making some serious effort to encourage the G20 to go further in offering debt relief to low-income countries under the umbrella of their Common Framework that was announced in late 2020. Currently only three countries — Chad, Ethiopia and Angola — have applied for debt relief under the framework and the IMF wants more involved. Things being what they are, the Fund may get its wish.

And since the Common Framework requires private creditors to participate on comparable terms with the G20, it looks like defaults to private creditors are set to increase. Maybe that’s no bad thing: If a country can’t pay its debt, then debt relief is entirely appropriate. And it is worth bearing in mind that private creditors tend to have short memories, allowing a defaulting country to return fairly fast to international capital markets. But debt defaults are often messy — one more thing to worry about in a world full of worry.