Like many other assets, emerging market debt (EMD) has seen sizeable losses as a result of the coronavirus (Covid-19) pandemic. Digging beneath the headline returns, there have been some interesting developments; here are five which caught my eye.
1) Record outflows from EM assets
In absolute terms, the outflows from emerging market (EM) assets have reached unprecedented levels. The Institute of International Finance (IIF) estimates that in March alone, portfolio outflows were $83 billion, split between $52 billion of equity and $31 billion of bonds, as illustrated in the chart below. However, as a percentage of total assets, the outflows are still less pronounced than in the global financial crisis (GFC).
In 2008 and 2009, the outflows from EM bond funds matched the inflows in the years preceding the crisis. Given the large inflows in the last few years, especially to hard currency funds, there is a danger that the outflows could continue to weigh on EM assets. That said, the investor base is likely more stable now, with a higher percentage of institutional investors.
One other point to note is that the chart below only shows non-resident flows, that is, foreign investors. An important feature of the market in recent years has been the growth of domestic - or resident - investors.
Both of these factors should limit the ultimate size of outflows.
2) US dollar shortage and liquidity injections
Historically, an important driver of EM assets has been the availability and price of US dollar funding. As investors and companies dashed for cash in March, in anticipation of the lockdown, US dollar liquidity conditions deteriorated substantially.
In order to alleviate the pressure in the offshore dollar market, the Federal Reserve (Fed) announced a number of measures. These include currency swap lines to other central banks, and enabling countries with US Treasury holdings to temporarily swap these bonds for cash.
These measures have provided some relief to EM. However, only select EM countries can currently participate in the programmes. For countries that do not have direct access to the Fed, or are facing persistent capital outflows rather than short-term liquidity issues, the measures do little to reduce the stress.
Nonetheless, the sharp increase in dollar liquidity, coupled with near-zero interest rates, could become a major tailwind to EM once the current crisis is resolved.
3) Wide dispersion of returns in hard currency EMD
The defining features of the sell-off in hard currency EM bonds have been the wide dispersion of returns and the fact that losses have been accrued by a small number of countries, as highlighted in the chart below.
In the JP Morgan EMBI Global Diversified Index, the ten countries that have seen the greatest spread widening in 2020 were less than 10% of the index at the beginning of the year, but have contributed almost 40% of the losses year-to-date.
Although it is expected that some countries fare worse than others, the large losses in a few key countries highlight the importance of avoiding the biggest “accidents” in EM.
Looking at the details, Lebanon, Ecuador and Argentina were already in trouble before the Covid-19 crisis escalated, culminating with Lebanon defaulting on its bonds in March. Other vulnerable countries, often reliant on commodity exports, have also seen the spreads of their US dollar bonds widen sharply.
The fate of these countries likely hangs on the actions of the International Monetary Fund (IMF) and international creditors. The distressed bonds offer alluring yields but come with significant uncertainty, and the attractiveness must be assessed on a country by country basis.
4) Most losses have been on the currency side in local currency EMD
In local currency EM bonds, almost all of the losses to international investors have come from currency depreciation. As the next chart shows, the currency component of the JP Morgan GBI-EM Global Diversified Index is down 15% year-to-date. The interest rate component, on the other hand, was positive until mid-March.
When extreme illiquidity in developed market (DM) government bonds led to a sharp spike in yields, EM government bonds sold off as well. Since then, the performance of currencies and bonds has diverged again, with the interest rate return now almost positive for the year.
This divergence can at least partially be explained by the actions of EM central banks that are perceived to be positive for bonds but negative for currencies, at least initially.
While losses in most asset classes have been sharp and sudden, EM currencies have been on a downward path for years and in some cases are now as cheap as they have ever been. For example, the Mexican peso is as cheap in real terms as it was in 1994 after the Tequila Crisis, as the following chart shows.
In most EM countries, the current accounts are now close to balance after years of large deficits. However, for some countries, having balanced current account might not be sufficient; meaning they could have to run a current account surplus, at least for some time as foreign capital exits. The fastest way for this to happen is through a compression in imports.
On the other side of the ledger, the broader US dollar strength could be coming to end, providing support for EM currencies. Still, as is the case with hard currency bonds, the value and prospect for recovery is not uniform across the countries.
5) EM central banks are not hiking rates, instead they are launching QE
The biggest difference compared to previous crises is that EM central banks have not hiked interest rates to defend currencies. For example, the South African central bank actually cut interest rates to a record low despite the plunging rand. Furthermore, a number of central banks have started to purchase local currency bonds to provide liquidity and stem the rise in long-term bond yields. The unfathomable EM quantitative easing (QE) has become a reality.
What has caused this paradigm shift? First, muted inflation and negative output gaps make the situation more manageable for EM central banks. Also, as local capital markets have evolved, there is less of a risk of currency mismatch for countries that borrow in foreign currency. However, there are some notable exceptions here, such as Turkey, that still have significant foreign currency borrowings. In addition, as the costs of handling the Covid-19 lockdowns are significant, and likely financed by additional government borrowing, the central banks could be expanding their arsenal to maintain market stability.
While a sign of a growing sophistication, the danger of EM QE is twofold. Some EM countries with large fiscal deficits might be tempted to rely on central bank financing. Given the weaker institutional back drop in EM, this could erode confidence and lead to higher bond yields, the very thing the QE programmes are intended to prevent. Secondly, looser monetary policy is clearly negative for EM currencies. Still in March, EM central banks used foreign currency reserves to defend currencies or at least slow the pace of depreciation, indicating that they will not let the currencies become completely unanchored.
What will it take for EM markets to stabilise?
While most markets have reacted positively to the unprecedented actions of global central banks and governments, a number of EM countries have struggled to regain their footing. This likely means that the international community will have to step up and provide support to the most vulnerable countries in the face of economic turmoil and capital outflows.
The G20 countries have already agreed to a debt standstill, freezing bilateral loan repayments for low-income countries until the end of the year. The IMF currently has a war chest of $800 billion it could use to help countries. But most IMF support in the past has come with the condition of debt sustainability and could take some time to put together. Besides debt relief, EM countries would greatly benefit from the gradual resumption of global economic activity and a weaker dollar.
The silver lining for investors is that the turmoil is likely to create significant opportunities. In the early 2000s, the last time some EM assets were as cheap as they are today, the crises in certain key EM countries helped to build the base for a sustainable recovery.
