Emerging markets (EMs) have shown financial resilience compared to advanced economies (AEs) in the first half of 2023.
Net capital inflows to EMs excluding China will total USD80bn this year, according to Institute of International Finance forecasts, having recorded net outflows of USD221bn in 2022.
JP Morgan’s EM local currency bond index returned 7.5% in the year to July 12, with Latin America returning 21% and Central and Eastern Europe 11%.
Compared with a GDP-weighted average of the sovereign bond yield in the United States, United Kingdom, euro-area and Japan, the spread between local currency borrowing costs in AEs and EMs has fallen to the lowest in over a decade.
The gap in policy credibility between AEs and EMs has narrowed. Central banks in Brazil, Mexico, Colombia, Poland and Hungary began raising rates to tackle inflation ahead of the U.S. Federal Reserve. Mexico, Peru, the Czech Republic and Poland could cut rates sooner than expected.
Robust Growth
In part, this reflects relatively more robust economic performance. The IMF expects EMs’ GDP to grow by 3.9% in 2023, similar to 2022, and higher than AE’s 1.3%.
The “EM growth premium”—the spread between EM and AE growth—will likely be the widest since 2013 in 2023 and 2024. The reopening of China, a crucial trading partner for EMs, particularly commodity exporters, will contribute to this.
The financial resilience of the major EMs also reflects a moderate easing of global financial conditions. The Global Financial Stress Index from the Office of Financial Research, which comprises credit, equity and volatility indicators, has eased since October 2022.
Weaker Dollar
A key contributor to global financial conditions is the U.S. dollar. Against a broad basket of currencies, the dollar appreciated by nearly 11% from January to October 2022 but has lost half this gain since.
A strong dollar is problematic for EMs. It increases the cost of dollar-priced imports, including intermediate goods, in global value chains.
It also tightens financial conditions by limiting dollar lending. This particularly challenges EM borrowers with heavy dollar-denominated liabilities.
Non-bank financial institutions’ lending to EMs has risen sharply in recent years, both directly and via banks. These institutions evaluate their returns and fund themselves mainly in dollars. Bank of International Settlements research shows that broad-based dollar appreciation significantly reduces lending from non-bank financial institutions to EMs.
Risks Remain
If inflation continues to decline and monetary policy tightening across the major AEs ceases by end-2023, the dollar will ease further, and global financial conditions will continue to improve.
However, the possibility of European and U.S. recessions might be destabilizing as they often trigger “flights-to-quality.”
Even if recession is avoided, instability in part of the sovereign debt market remains likely as global financial conditions remain tight historically.
Not all EMs will cope with this. Smaller frontier EMs have seen significant increases in interest rates, and many are in debt distress.
The IMF’s April Global Financial Stability report indicates that eight developing economies are in default and twelve are in non-defaulted debt distress. The report highlights that 37 of 69 low-income countries are in or near debt distress or default.
Zambia, Ghana, Pakistan and Sri Lanka have recently made some debt restructuring progress. However, higher interest rates challenge the heavy refinancing needs of debt-distressed economies.
The Debt Justice organization estimates that the external debt payments of 91 developing economies will average 16.3% of their government revenues this year and 16.7% next year, up sharply from a decade ago.
The difficult conditions some EMs face can be attributed to country-specific policies and global forces. Monitoring the interaction between the two is crucial.
Geopolitics
Beyond the dollar and global financial conditions, geopolitics will impact EM’s financial stability over the longer term, as, like climate change, it can generate unpredictable shocks with significant consequences.
IMF research this year finds that global geoeconomic fragmentation is rising and will significantly impact long-term global growth prospects.
Against concerns about national security and global value chains being restructured, dollar access might depend on international relations more than market forces. It is partly due to geoeconomic fragmentation that capital inflows to China have not rebounded this year, in contrast to the positive EM trend excluding China.
Climate Change
Climate change significantly affects the resilience of global value chains, particularly for commodities vulnerable to global warming. This can generate unpredictable shocks with repercussions for the stability of lending and asset prices.
Investors may be overlooking such shocks. A new report from the U.K. Institute and Faculty of Actuaries and the University of Exeter shows that current financial sector models significantly underestimate the economic impact of climate change and warns that downside risks may develop more rapidly than expected.
