When it comes to possible debt default, most systemically large EMs have upped how they manage their fiscal and monetary policies, while the EMs most at risk are mainly very small. A dual investment approach should make the best of both.
A duality in outcomes: ‘Good’ versus ‘bad’ emerging markets
Investors are right to question where there is a debt crisis in emerging markets (EM). We have been concerned about the rise in EM debt levels for some time. I was involved with the HIPC and G7 debt relief initiatives that effectively wiped out the debt of the poorest countries. Fifteen years on, these same countries have racked up debt at market interest rates to an unsustainable degree and in an irresponsible way. It is our belief that this presents an imminent threat and it is our fiduciary duty to protect our clients from this latent risk.
There is an argument that debt has become a systemic problem in EM. Taking a group of high-yielding EM countries as an observation, the average debt to GDP ratio rose from 36% in 2012 to 59% in 2017. Only a subset of these countries is responsible for the most dramatic increases.
Debt alone does not trigger a crisis – there must be some catalyst for investors to lose faith. Academics have definitively shown that most debt crises begin as currency or banking crises. Indeed, many of the most highly indebted countries have credible backstops in the form of central bank reserves or other foreign assets, credit lines with major central banks and trading partners, and good relations with the International Monetary Fund (IMF) or other lenders of last resort. Witness the recent salvos by Bahrain and Pakistan, both of which have clearly unsustainable debt, but for which default is absolutely unthinkable.
The countries most at risk are small fry…
Ultimately, our team is most preoccupied with those countries that have unsustainable debt and whose solvency constraints appear likely to become problematic both in terms of liquidity and the ability to repay. We see two clear signals for this: (1) how much of the country’s annual budget is eaten up by debt service, and (2) the country’s ‘hot money’ to reserves ratio.
The markets that we believe face a non-trivial risk of distress or default over the near term include Angola, Belize, Congo, Gabon, Lebanon, Mongolia, Mozambique, Sri Lanka, Ukraine, Zambia. Yet these 10 countries together comprise only a small fraction of our investable universe. Even if we take the next six likely default candidates in our analysis, none is particularly large or systemically important.
… whereas the bigger fish have upped their game
Most large EMs with economies large enough to actually rattle global markets have in fact improved their policies over the past cycle: better external accounts, more robust fiscal and monetary management, lower inflation, more competitive currencies. Brazil, Indonesia, Malaysia, Mexico, Russia and South Africa: each of these looks better than it did five years ago across a variety of metrics, including governance.
Collectively, these good stories comprise the majority of our benchmark market capitalisation. For the first time in years, we are seeing more upgrades than downgrades at the asset class level; indeed, we believe the ratings cycle has turned definitively for EM as a whole – and that this will continue.
These are interesting markets to own at the moment, especially given the improvement in valuations from the recent sell-off, and as a medium-term view. Even if we dip our toes into the troubled waters of our universe, such as Turkey and Argentina, we do not yet see that these larger and systemically relevant countries have gone through anything but a currency crisis.
Biggest near-term risk is a collective default of smaller, highly-stressed EMs
When will the broader EM debt crisis reach its Minsky moment? We need look no further than Greece for evidence that the status quo can continue for many years before capitulation. The biggest near-term risk seems not to be the default of a systemically significant emerging economy but rather the collective default of a group of multiple smaller, more highly-stressed countries. A collective default could be encouraged by the IMF or another supranational agent, but far more likely in our view is a series of events in which the markets simply become frozen for these borrowers and – through a combination of peer coordination and contagion – their default option is to default, as it were.
To conclude, we believe a steady, dual approach is wise for EM: forgo potential short term performance by avoiding potential blow-ups, take the opportunities the recent sell-off has given to overweight positive cases. Good vs Bad neutralised – for now.
Heavily Indebted Poor Countries
Moody’s Sovereign Statistical Handbook, December 2017
Portfolio investment, including equity and investment fund shares and debt securities, plus loans, currency and other short-term deposits, as a ratio to the country’s hard currency reserve assets.”
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