Persistently high inflation throughout 2021 and into 2022 has forced global Central Banks to begin a tightening race to cool inflation. This has led to a massive surge in yields around the world. The Federal Reserve has thus far this year hiked 375 basis points and is expected to continue to raise rates in subsequent meetings, pushing global rates up. This has been detrimental to emerging markets around the world, as borrowing costs have soared and debt issuance markets have begun to dry up. However, we have seen some bright spots, led by strong Central Bank performance and support from commodity markets.
The Big Story:
Yield spreads in Emerging Markets have risen close to 200 basis points from the low point experienced during the latter part of the COVID pandemic. This rise in yields has been on the back of higher yields in the United States, which has led investors to demand a higher return from Emerging Markets for their higher risk. The Emerging Market Hard Currency spread is currently 600 basis points, and the spread for High Yield Hard Currency Emerging Markets is close to 1,000 basis points. These spreads remain below the high at the beginning of the pandemic, yet they are fast approaching. The question now becomes where spreads will go, and if we will start to see increased debt crises and instability in emerging markets.
The Drivers:
Inflation and Central Banks hikes have been the main driver behind the movement of global debt markets this year. As mentioned, the Federal Reserve has hiked 375 basis points. On top of that, the Bank of England has hiked 300 basis points since it started its hiking cycle, and the ECB has hiked 200 basis points thus far this year. These Central Bank hikes have occurred as inflation continues to be persistently high. Inflation in Europe and in the UK is above 10% and inflation in the US 7.7%. Global inflation is expected to be close to 8%. This persistently high inflation means that Central Banks are unlikely to make a significant pivot any time soon.
The Bright Spots:
We have seen some bright spots, especially in Latin America. Central Banks in Chile, Mexico, and Brazil started hiking rates during mid-2021. This has meant that Central Banks in these countries have kept a significant yield differential to the US. Because of this, we have not seen a repetition of what we saw during the 2013 taper tantrum, where spreads exploded, and currencies were severely hit. In fact, this year the Mexican Peso is up on the US Dollar, and the Brazilian Real has outperformed the Great Britain Pound and the Euro. These countries have also benefited from soaring commodity prices, which has led to strong export numbers. All this has meant that these countries have not yet seen a potential debt crisis.
The Less Bright Spots:
Despite the success of countries like Mexico and Brazil, we have started to see some cracks in some countries. Countries like the Bahamas have faced significant pressure from soaring import costs from food and energy. This has hit the current accounts and has led to a substantial depreciation of their currency. This has led to significantly more pressure on their debt and finances and has sent spreads soaring.
We have also had cases like Turkey, where inflation has run out of control, yet the Central Bank is decreasing rates for political reasons. This has led to a crisis of confidence on the part of international investors, putting significant pressure on the lira and raising spreads.
Finally, the existing environment has also led to social unrest, as seen in Sri Lanka, where protests earlier this year toppled the government. This political instability was fueled by soaring energy and food prices.
The Outlook:
Going into 2023 there are a lot of uncertainties about where the debt markets are going. The success of Mexico and Brazil this year has been an indication that thus far, emerging market trading has primarily been interest rate differential based, as opposed to growth based. However, if as we enter 2023, we start to see increasing signs of a global slowdown, this could shift trading to growth based, being detrimental to emerging markets. We could see a continued rise in spreads led by growth fears, coupled with increasing pressures on the currency, leading to an increased potential of a debt crisis. And more concerning is how long the issuance markets remain relatively closed. Emerging markets as a whole seem capable of weathering a storm in 2023, but if conditions remain tough beyond that, we can start to see real cracks.
This article was written by Ricardo Cervera, a first-year BSc Economics student at the LSE
LSESU Developing Markets Society 