The key unknown of predictions is often the timing…
Have you ever been to a fortune teller? I tried it once, approaching the experience with a fair degree of scepticism. Looking back, many of the comments were quite generic, but some of the other ‘readings’ ended up being surprisingly accurate. The key unknown of these predictions remains the timing. When it comes to predicting market dislocations, it feels that investors can rarely spot a crisis before it unfolds.
Yet looking in the rear view mirror, the warning signals often appear quite obvious. Only recently we were on the brink of the collapse of the UK pension fund system, following extreme volatility in the British pound and gilts – an event that very few had predicted.
When it comes to emerging markets (EM), there are often plenty of volunteers lining up to predict a doom and gloom scenario for the asset class, especially during times of uncertainty. Commentators point to a range of potential 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, I would observe that there is a growing distinction between a group of countries that are in a stronger position, benefitting from a few tailwinds that support the broader EM beta investment case, and those that are likely to face a crisis ahead.
Key tailwinds supporting a constructive case for investing in EM are the strong commodity backdrop and orthodox monetary policy. The commodity backdrop has translated into a meaningful improvement in the current account dynamics for the majority of EM countries, with over two-thirds of the universe being commodity exporters. Orthodox hawkish monetary policy in most EM countries has resulted in close to double-digit policy rates following two years of rate hikes, allowing them to be on the front foot when it comes to inflation management.
When it comes to liquidity, the depth of the domestic market is equally important. Out of USD23 trillion of EM fixed income assets, only USD4 trillion are denominated in hard currency. Over the last 20 years, several EM countries have actively developed deeper local markets that allow them to rely on domestic markets when external markets are closed. So, those who argue that EM are likely to relive the 80s style balance of payment crisis might be overly pessimistic, given the dynamics and evidence of policy evolution above.
However, higher US Fed rates will create headwinds for a select group of EM countries, and possibly structurally impair their ability to service their debt. Frontier economies -- the segment of EM 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 the Sub-Saharan African credits haven’t fully recovered from Covid, with only 20% vaccination rates, and have witnessed 28 million people falling into extreme poverty over the last three years.
Net exports have detracted from growth during this time and consumption is currently under pressure, given the high level of inflation. The growth outlook is even bleaker, with the limited resources for investment and constraints on the 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 GDP. These countries have also sustained the fastest growing stock of debt, with bond issuance alone increasing from USD5 billion in 2009 to USD100 billion in 2021. So far, the region has received USD30 billion of developmental assistance and USD60 billion of IMF 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 into these countries without being confident that the issues outlined above 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 in this segment of the market? We think the risk of the latter outcome cannot be discounted. Despite the willingness to pay and implement a correct policy mix, the Covid pandemic and raw material pressure, combined with a relatively high debt load and higher global funding rates, puts 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 in a sovereign debt restructuring 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 going forward and put debt servicing on a sustainable path.
We would argue that in the case of Sub-Saharan Africa a comprehensive approach would be most effective, but it would likely require some features that are new to the market. These would focus not only on the existing debt, that could be reprofiled in a new instrument linked to key Sustainable Development Goals as KPIs, but also on potentially providing additional liquidity through an ESG-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 SDR (Special Drawing Rights) as a backstop for lending. In 2021, Sub-Saharan Africa received USD20 billion in SDR out of the total pool of USD660 billion. 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 conditionality and tighter monitoring could be a win-win for both investors and countries in need. Looking back in history, 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 EM and gave birth to EM sovereign debt as an asset class.
Why should investors care if they can avoid the space? The continent is home to 1 billion people, 30% of 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 CO2 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 USD1.6 trillion between 2022 and 2030 to meet their Nationally Determined Contributions to fight climate change, but on current trends is raising less than 10% of that amount. With the financial burden of mass poverty and 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.
While fortune tellers might struggle to predict the future, they often provide some clues that could be helpful in navigating a challenging period in our lives. Today we see a number of structural challenges that are facing frontier economies. We ought to pay attention to these clues and act proactively in order to avoid a crisis on our doorstep. It is certainly easier to get into a crisis than to get out of it.