EM: Hit Me One More Time

Around the Curve

EM: Hit Me One More Time

Slowing growth, de-globalization, and higher savings rates may warrant greater caution and selectivity with respect to emerging markets debt over the next decade.


A black swan virus shock has brought the world to its knees—dealing a particularly acute blow to emerging markets. It was only a year ago that developing markets had emerged from the previous Federal Reserve (Fed) tightening and trade war crises. Britney Spears’s "…Baby One More Time" seems like an apt description for the series of shocks that emerging markets have gone through. However, this time around both developed and emerging markets have experienced large currency depreciations as seen in volatilities. Yet this might morph into more of an emerging market stress than previously imagined. As we sit here sifting through the effects of COVID-19, we reflect on some of the stresses emerging markets may face and assess the road ahead.

Emerging Markets Under Stress

Chart 1 shows a comparative ranking of emerging market health systems, relative to one another and developed markets. With weaker healthcare systems relative to developed markets, emerging economies may be less equipped to handle a pandemic like COVID-19. India, Philippines, Poland, Turkey, South Africa, Mexico, and Brazil have issued an economic-wide shut down once they realized how critical the health crisis would be, although some were very late or too slow.


Source: Maplecroft. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


Added to the health crisis was the liquidity squeeze caused by a global rush for U.S dollar cash. Even in this environment, the traditional relationship has held up, with currencies continuing to show a strong correlation to credit spreads in the U.S. (Chart 2). With the Federal Reserve (Fed) and U.S government stepping in to do whatever it takes to ease both liquidity and credit market conditions, some stress across global currencies has eased on the currency basis. To this extent, the Fed has extended swap lines to major central banks in Europe, Japan, Switzerland, Australia, New Zealand, Norway, Mexico, Brazil, South Korea, and Singapore.

Source: Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


But even as the liquidity squeeze eases, emerging market fiscal deficits and balance sheets remain in focus. Countries globally are spending more to fill the hole left by the economic shutdowns. Concurrently with the demand shock, oil prices have collapsed, resulting in a deep revenue squeeze for many commodity-based countries. It is therefore not inconceivable that fiscal deficits will be expanded by more than twice the amount seen during normal times. Some countries can afford to do so while others simply cannot (Chart 3).


Source: Haver, Macrobond. Past performance is no guarantee of future results. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


It is during such times that countries need financing. Yet private capital flows have almost all but dried up. The ratio of foreign exchange reserves to gross external financing is a chart to revisit every time financial market stress accelerates (Chart 4). Clearly some countries are more vulnerable to sudden stops in portfolio flows while others have sufficient foreign exchange reserves to see it through for a year—even if banks are unwilling to roll over all short-term external debts, or investors show a buyer strike at bond auctions. The vulnerable countries after accounting for extended swap lines are Argentina, Turkey, South Africa, and Chile.


Chart 4 Note: When foreign exchange reserves fall below 1.00 to external financing needs, a country could face financing issues when capital flows stop.

Sources: Haver, Institute for International Finance. Past performance is no guarantee of future results.This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.


The International Monetary Fund has responded by pledging a $1 Trillion line to vulnerable countries to tide over this crisis, which has helped smaller emerging markets. The larger ones have reacted by allowing their currencies to depreciate to some extent while engaging in intervention and/or modest quantitative easing to keep their bond markets functioning with lower rates. Altogether, emerging markets have also lowered rates by some 50 to 100 basis points.

Have Currencies Depreciated Sufficiently? Who Likely Recovers First?

With currencies having depreciated by some 6% to 25% across different emerging markets, the question is whether currencies have depreciated enough such that there would be an economic feedback via the current account.


Sources: Haver, Bloomberg. Past performance is no guarantee of future results. Indexes are unmanaged, and not available for direct investment. Index returns do not include fees or sales charges. This information is provided for illustrative purposes only and does not reflect the performance of an actual investment.

Looking at Chart 5 suggests that some currencies have depreciated sufficiently to counter the virus shock. One could make a judgment that the virus shock will change the economic landscape structurally, and therefore, currencies may need to depreciate further to the new norm. In light of the currency depreciations, it pays to be careful in sifting through the quality versus weak emerging markets. If a large emerging market were to default, it may cause a U.S. dollar squeeze once again across the spectrum.

Despite how gloomy the world may be now, we cannot and will likely not remain in this dismal state forever. Medicine and science are advanced and the likes of China and Korea have shown that we can overcome the virus. In envisioning a recovery, emerging markets that have a larger reliance on manufacturing exports—South Korea and Taiwan in Asia, and the Czech Republic and Poland in Europe—are likely to recover first as the China experience suggests. Many of these manufacturing economies have sufficient U.S. dollar liquidity with swap lines and no external financing issues. In the next tier of higher-yielding countries—ones with some fiscal discipline but flexibility, fewer issues with external financing needs, and credible central banks—like Indonesia, Russia, and Mexico, are perhaps likely to be able to tide over this stressful period more quickly than others.

The Long Road Ahead

The structural landscape is changing rapidly for emerging markets. As noted by my colleague Tracy Chen in her article "The Unintended Consequences of COVID-19", there would be a reshuffle of global supply chains after the dust settles from the virus outbreak. China’s growth may slow more drastically as the major G3 economies realize the perils of supply chain concentration. However, ultimately emerging markets depend on China’s growth. Nevertheless, China’s economy will recover as the credit impulses imply, though its efforts will be focused more on investing in new technology and infrastructure, rather than piling into old-school infrastructure stimulus. Due to the virus, emerging markets will yet again engage in more borrowing leading to an even larger debt pile. Overall, the global economy will reopen slowly and in stages due to extreme caution around the virus and the potential for second-wave outbreaks. Against a backdrop of slowing growth, de-globalization, and higher savings rates globally, this may warrant exercising more caution and selectivity with respect to emerging markets over the next decade.

Abbreviations for Charts 1 and 3:

Abbrev Country/Currency)
ARS Argentina (Argentine Peso)
BRL Brazil (Brazilian Real)
CLP Chile (Chilean Peso)
CNY China (Chinese Yuan)
COP Colombia (Colombian Peso)
DM Developed Market
HUF Hungary (Hungarian Forint)
IDR Indonesia (Indonesian Rupiah)
INR India (Indian Rupee)
KRW Korea (Korean Won)
MXN Mexico (Mexican Peso)
MYR Malaysia (Malaysian Ringgit)
PEN Peru (Peruvian Sol)
PHP Philippines (Philippine Peso)
PLN Poland (Polish Zloty)
RUB Russia (Russian Ruble)
SGD Singapore (Singapore Dollar)
THB Thailand (Thai Baht)
TRY Turkey (Turkish Lira)
ZAR South Africa (South African Rand)


Abbreviations for Chart 2:

CDX IG CDSI Gen 5Y Corp Credit Default Swap, Investment-Grade Generic 5-Year Corporate Bonds
USDMXN Currency Mexican Pesos per U.S. Dollar
AUD Currency U.S. Dollar per Australian Dollar



G3 refers to the world's top three developed economies: US, Europe and Japan.

The real effective exchange rate (REER) is the weighted average of a country's currency in relation to an index or basket of other major currencies. The weights are determined by comparing the relative trade balance of a country's currency against each country within the index.

Foreign exchange (FX) refers to markets and rates for currencies.

The black swan theory or theory of black swan events is a metaphor that describes an event that comes as a surprise, has a major effect, and is often inappropriately rationalized after the fact with the benefit of hindsight.

Emerging markets (EM), also known as developing markets, are nations with social or business activity in the process of rapid growth and industrialization. These nations are sometimes also referred to as developing or less developed countries.

COVID-19 is the World Health Organization's official designation of the current coronavirus disease.

A pandemic is the worldwide spread of a new disease.

Correlation is a statistical measure of the relationship between two sets of data. When asset prices move together, they are described as positively correlated; when they move opposite to each other, the correlation is described as negative or inverse. If price movements have no relationship to each other, they are described as uncorrelated.

A credit spread is the difference in yield between two different types of fixed income securities with similar maturities, where the spread is due to a difference in creditworthiness.

The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.

Liquidity swap lines are designed to improve liquidity conditions in dollar funding markets in the United States and abroad by providing foreign central banks with the capacity to deliver U.S. dollar funding to institutions in their jurisdictions during times of market stress.

The International Monetary Fund (IMF) is an international organization of various member countries, established to promote international monetary cooperation, exchange stability, and orderly exchange arrangements.

Quantitative easing (QE) refers to a monetary policy implemented by a central bank in which it increases the excess reserves of the banking system through the direct purchase of debt securities.

One basis point (bps) is one one-hundredth (1/100, or 0.01) of one percentage point.

In economics, and especially in contemporary macroeconomic modeling, impulse response functions are used to describe how the economy reacts over time to exogenous impulses, which economists usually call shocks, 


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