When it comes to predicting market dislocations, investors can rarely spot a crisis before it unfolds. Yet in hindsight, the warning signals often appear obvious. In September and October, the UK was on the brink of a collapse in its pension fund system, following extreme volatility in the pound and gilts market – an event few had predicted.
When it comes to emerging markets, there are plenty of volunteers lining up to predict a doom-and-gloom scenario, especially during times of uncertainty. Commentators point to a range of triggers: balance of payments crises, liquidity tightening (given countries’ reliance on external markets), sharp currency devaluations and geopolitical risk. The asset class has registered its worst performance on record, with EM hard currency debt down close to 25% in the first nine months of this year. The sell-off has been indiscriminate. However, there is a growing distinction between a group of countries that are in a stronger position, benefitting from tailwinds that support the broader EM beta investment case, and those that are likely to face a crisis.
Tailwinds that support EM investing include the strong commodity backdrop and orthodox monetary policy. The commodity backdrop has translated into a meaningful improvement in current account dynamics for the majority of EM countries, with over two-thirds of the universe being commodity exporters.
Orthodox hawkish monetary policy in many EM countries has resulted in close to double-digit policy rates following two years of hikes, allowing these countries to be on the front foot on inflation management. When it comes to liquidity, the depth of the domestic market is equally important. Out of $23tn of EM fixed income assets, only $4tn is denominated in hard currency. Over the last 20 years, several EM countries have developed deeper local markets which they can rely on when external markets are closed. So, those who argue that EMs are likely to relive the 1980s style balance of payment crisis might be overly pessimistic, given the dynamics and evidence of policy evolution.
However, higher US rates will create headwinds for a group of EM countries and impair their ability to service their debt. Frontier economies – the segment that includes smaller countries with high reliance on external funding – are likely to be vulnerable to landing in this position. These economies comprise roughly 9% of the EM tradeable universe. Countries in sub-Saharan Africa, specifically, account for almost half of the JP Morgan NEXGEM Frontiers Index. Many of these countries haven’t fully recovered from Covid-19, with vaccination rates of only 20%, and have witnessed 28m people fall into extreme poverty over the last three years.
Net exports have detracted from growth during this time and consumption is under pressure, given the high level of inflation. The growth outlook is even bleaker, with limited resources for investment and constraints on government budgets. This deterioration adds to already large structural imbalances, with 60% of sub-Saharan African economies in the index facing twin deficits above 10 percentage points of gross domestic product. These countries have also sustained the fastest growing stock of debt, with bond issuance alone increasing to $100bn in 2021 from $5bn in 2009.
So far, the region has received $30bn of developmental assistance and $60bn of International Monetary Fund emergency funding. With the existing elevated levels of indebtedness (debt-to-GDP in high double digits) and high gross financing needs, it seems unlikely that either bilateral lenders or bondholders would be prepared to lend more money to these countries without being confident that these issues will be addressed.
Could this play out over the next couple of years in the form of ad-hoc sovereign restructurings or are we likely to see a broader spillover in the region that could impair regional growth prospects and investors’ risk appetite? The risk of the latter outcome cannot be discounted. Despite the willingness to pay and implement a correct policy mix, the pandemic and raw material pressure, combined with a relatively high debt load and higher global funding rates put the sub-Saharan African economies’ debt profile on an unsustainable path.
When approaching a restructuring, the challenge in applying an appropriate framework doesn’t lie in agreeing on the magnitude of the haircut required to repair the sovereign balance sheet. The real challenge lies in creating a framework that brings direct investment and portfolio flows, as well as a policy mix that is designed to improve growth prospects and put debt servicing on a sustainable path.
In the case of sub-Saharan Africa, a comprehensive approach would be most effective, but it is likely to require some features that are new to the market. The focus should not be limited to existing debt that could be reprofiled in a new instrument linked to sustainable development goals as key performance indicators. Attention should also be paid to providing additional liquidity through an environmental, social and governance-linked ‘new money’ solution that could be tightly monitored and linked to specific strategically important projects. If a broader investor pool were to be targeted, these new money solutions could also offer high-quality collateral for additional comfort.
One such example could entail tapping into international reserve assets such as special drawing rights as a backstop for lending. In 2021, sub-Saharan Africa received $20bn worth of SDRs, out of the total pool of $660bn. Currently, a number of developed countries do not use their share of the SDR allocation. Putting together a framework that could reallocate a share of this amount towards frontier market economies with attached conditions and tighter monitoring could be a win-win for both investors and countries in need. This type of framework can be loosely compared to the Brady bonds plan in the 1980s that helped reprofile most of the commercial debt of EMs and gave birth to EM sovereign debt as an asset class.
Why should investors care if they can avoid the space? Africa is home to over 1bn people, 30% of the world’s mineral reserves, 12% of the world’s oil reserves and 8% of the natural gas supply. In addition to the economic and humanitarian motivations, there are environmental arguments for providing ESG-linked capital to sub-Saharan Africa. The region currently accounts for only a small fraction of carbon dioxide emissions globally, yet a recent study by the Mo Ibrahim Foundation reports that the continent contains the 10 most climate-vulnerable countries in the world.
The IMF and African Development Bank estimate that Africa as a whole needs to mobilise $1.6tn between 2022-30 to meet their nationally determined contributions to fight climate change. On current trends, it is raising less than 10% of that amount. With the financial burden of mass poverty and a lack of resources, it is optimistic to expect that net zero and adhering to Paris club agreements will feature strongly on the priority list for policy-makers.
Frontier economies are facing structural challenges. Attention and action are needed to avoid a crisis. It is certainly easier to get into a crisis than to get out of it.
Polina Kurdyavko is Head of Emerging Market Debt, BlueBay Asset Management.