The beginning of the year had been very promising for the emerging markets. Bond and equity funds received strong inflows in January on the back of China’s reopening and easing inflationary pressures around the world. According to data from Refinitiv Lipper, which covers more than 33,700 emerging market (EM) funds, stock funds received $13.2bn, and bond funds received $11.36bn. Both innings were the biggest in over a year.
But just when everything seemed to presage that the trend could extend to the rest of the year, turmoil in the financial sector arrived, threatening to ruin everything. “The tensions in the American and European banking system are a symptom of increasing cracks in a context of tightening financial conditions“, Explain Mali Chivakul, Emerging Markets Economist at J. Safra Sarasin Sustainable AM. “Despite prompt responses from authorities, the global financial market remains volatile and emerging market assets are likely to continue to suffer in this environment.”
Chivakul acknowledges that emerging market banks “have held up better than their money market counterparts in the latest bout of stress.” Overall, fundamentals “are quite strong, with stable deposit funding and a traditional lending model.” In addition, “its capital adequacy has been strengthened over the years.” However, “they also face potential stresses from tightening financial conditions, both globally and domestically.”
“Beyond the general economic slowdown, some emerging markets have overextended credit to the economy, pointing to increased credit risk and losses as rates rise and the economy slows down,” the expert believes. by J. Safra Sarasin.
Data from the Bank for International Settlements (BIS) on the credit gap, which is essentially the extension of credit above long-term trends, shows that only Thailand and South Korea stand out. Brazil and Hungary also show small gaps. Thailand and Korea have been known for their household debt problem. The rise in interest rates in Korea has been steeper and faster since its central bank started raising its policy rate in 2021. Late last year, Korea already experienced some financial stress as the real estate sector slowed sharply. Thailand opted for a slow path of interest rate hikes, mainly on concerns about household debt.
Several banks in emerging countries have absorbed more government bonds during the pandemic years, as foreign investors left and governments borrowed more to spend on Covid-19 aid. “In many countries, These public debt holdings are valued at market prices (more than 70% on average, according to the IMF), so they are subject to the risk of revaluation and losses”, Warns Chivakul.
“Countries with large current account deficits and that depend on foreign financing will continue to be subjected to market pressure and the tightening of global financing in dollars”, highlights the expert
Emerging Market Debt Outlook
If the focus is placed on the debt of the emerging countries, the three main factors conditioning the evolution at the beginning of the year were the financial situation in the US, the dollar and world growth. “It seems likely that all three factors have been altered by the current turmoil in the banking sector,” he believes. Kirstie Spence, Portfolio Manager at Capital Group. “While in theory a less aggressive Fed is a positive for emerging markets, it is likely that a US recession, a strong dollar and increased risk aversion create a less positive environment for emerging market debt”.
However, “although the global context remains a drag on emerging markets, the relative strength of the macroeconomic fundamentals of the main emerging countries, combined with the high starting yields and the undervalued exchange rates of local currency debt , they should cushion any new volatility.”
In addition, “it should be remembered that while the current volatility of the markets may seem overwhelming, Emerging market debt has become a broad and diversified universe with various instruments available to investors to position themselves against different risks”, emphasizes Spence. “As in the case of Ukraine, investors were able to rotate their portfolios to less affected regions and the same can be done around the current volatility in the banking sector.”
