- Global context: recovery from the deep covid-19 dip has started, as economies reopen
- Covid-19 shock brings record EM portfolio outflows in March, followed by modest recovery
- Despite some positive recent signals, EMs still severely hit, particularly commodity exporters
- Government finances – already deteriorated since GFC – to worsen further
- Emerging Asia: China leads post-covid-19 rebound, but external headwinds remain
- Latin America: the worst is not over yet
- Emerging Europe hit by eurozone, commodity and trade weakness
- In search of the most vulnerable EMs using our own risk heatmap
Global context: Recovery from the deep covid-19 dip has started, as economies reopen
The rapid spread of covid-19 beyond China earlier this year has led to emergency measures around the globe, including hard or softer lockdowns. These are triggering a breath-taking contraction of the global economy, particularly in Q2. Worldwide, authorities are reacting by adding large-scale fiscal and monetary stimulus. On the monetary policy front, the Fed has cut its main policy rate by 150 bps to 0-0.25%, indicating that rates will stay near zero at least to 2022. The Fed also has made a ‘whatever it takes’ type commitment to purchase as many assets as necessary to promote smooth market functioning and is implementing a range of congressional lending programmes to provide liquidity to businesses in need – potentially up to $4trn depending on demand. The ECB meanwhile has kept its policy rates (already negative) constant, added forward guidance and sharply increased its QE programme including the introduction of the EUR 1350 bn Pandemic Emergency Purchase Program (PEPP).
Notwithstanding these and other support measures, we have sharply lowered our 2020 annual growth forecasts for all advanced and emerging economies that we cover. Regarding the advanced economies, we now expect the US economy to contract by almost 5% this year and the eurozone economy by almost 7%. We also sharply reduced our emerging market (EM) growth forecasts for 2020, from an aggregate +4.1% in January to -1.5% now. Only for a few Asian countries we expect modest positive growth in 2020. That includes China, although we have cut our China forecast from almost 6% to 2%. For most EMs we expect negative annual growth this year, although with strong variations between countries. We expect Latin America to be hit the most followed by emerging Europe and emerging Asia.
On a brighter note, more and more economies are gradually reopening again. China is leading a post covid-19 industrial rebound. We expect a sharp global recovery in Q3 on these reopenings, as is also indicated by the forward looking PMIs. Financial market sentiment has also improved on this prospect. Still, our base case for the global economy assumes a bounce in activity around the middle of this year to be followed by renewed weakness, for several reasons: 1) exits will be gradual, 2) the possibility of stop and start, 3) no silver bullet solution (like a vaccine) in the near term, 4) consumer caution and 5) second round effects (such as rising unemployment and bankruptcies) take time to work through (see here for more background on our global scenarios). That said, in annual growth terms we expect the sharp 2020 dip to be followed by above trend global growth in 2021, mainly reflecting base effects. For EMs, we expect annual growth to accelerate to more than 5% next year. However, the pandemic will leave its mark: by end 2021 emerging markets will have lost around 5% of GDP compared with our pre-covid-19 base case.
Covid-19 shock brings record EM portfolio outflows in March, followed by modest recovery
The covid-19 shock has hit emerging markets hard through the capital flow channel as well. In the spring of this year, market sentiment deteriorated very sharply, when the virus started to spread beyond China rapidly and widely. This created an extreme risk aversion among market agents, which led to sharp corrections in basically all asset markets globally. Such an extreme ‘risk off mood” in international capital markets typically results in an outflow of (non-resident) portfolio flows from the ”higher risk” emerging market assets. According to IIF data, monthly (non-resident) portfolio outflows from EMs – both debt and equity – added up to a record high of USD 83 bn in March. That implies that the outflows in March were higher than the amounts seen during any single month at the times of the global financial crisis in 2008-09, including the previous record of USD 63 bn in October 2008 (just after the collapse of Lehman Brothers). We should add that during the GFC, capital outflows in late 2008 lasted for four months in a row, while in the current crisis portfolio flows to EMs have cautiously returned in April and May.
All this is consistent with the unexpected nature of the covid-19 shock, with market agents having to adjust their portfolios at an extremely high speed, while the GFC took much longer to unfold. The pattern of sharp outflows in March followed by a modest recovery in April and May was seen in all EM regions and true for both debt and equity flows. That said, some individual countries remained under pressure for longer, with both equity and debt flows still negative in April and/or May for Brazil, Turkey, South Africa, Malaysia and Thailand.
Despite some positive recent signals, emerging markets still severely hit
In the first months of this year EMs were not just faced with a sharp drop in external demand and commodity prices, but obviously suffered from the impact of stringent lockdown measures in their own countries as well. In addition, increased risk aversion led to a spectacular collapse in portfolio inflows and a strong depreciation of many currencies.
More recently, we have seen a recovery in different emerging market indicators. Foreign capital returned, currencies recovered part of their value, commodity prices went up, CDS spreads dropped again and stock markets rose in many key EMs. More monetary stimulus in the developed world and positive signals from the US and China led to a fall in risk aversion and brought some appetite back for riskier EM assets. EMs are profiting from the even more lower for longer global interest rate environment, especially since risk aversion has fallen. While this has partly reversed the dramatic initial impact of the covid-19 virus, we believe that it is too early to conclude that the worst is over. Given all the remaining uncertainties, it is quite possible that risk aversion will flare up again, potentially resulting in a renewed tightening of financial conditions.
Furthermore, as mentioned earlier, global demand will remain weak and hence the revival of commodity prices will be limited. Tourism is not expected to recover soon and remittances from migrant workers will probably not recover quickly either. As a result, current account deficits in many countries will widen substantially. Energy exporters, such as Nigeria, Russia and Saudi Arabia, are having to deal with a loss of one third to half of export revenues, while exporters of industrial and agri commodities are facing a sharp drop in prices and reduced external demand. Examples include metal exporters Peru and Chile, with half of their export proceeds coming from industrial commodities, as well as South Africa, for which 25% of its export proceeds are dependent on industrial commodities.
This is all aggravated by the fact that in many EMs the worst of the outbreak is not over yet. Moreover, the capacity to containing Covid-19 is limited in many countries given underdeveloped health systems. This might lead to the need for longer lasting social distancing measures, which will continue to weigh on economic outcomes. The crisis also painfully exposes the precarious state of the health and education systems and the wide income differentials in many EMs. People who are working in the informal sector suffer most from lockdown measures and have the least access to proper health care. People that only recently joined the middle class may be thrown back into poverty. This all increases the risk of social unrest, which could damage the recovery as well. Meanwhile, fiscal space to cushion the fallout has decreased over the past decade for many EMS, particularly for commodity exporters. On a positive note, however, inflation is at low levels in many EMs. This has created room for extensive monetary easing in EMs, helping to cushion the blow.
Extensive multilateral aid programmes from the IMF, World Bank and regional development banks amongst others will bring some relief, but will not prevent most EMs from falling into a deep recession and many already highly indebted countries struggle with their debt-service obligations. Since the start of the pandemic, the IMF, World Bank and regional development banks have provided emergency financing for 66 countries, for a total of $23.6bn. With the exception of some $200m in debt relief, mainly in Sub-Saharan Africa, this has taken the form of liquidity support under the Rapid Financing Instrument (RFI) and Rapid Credit Facility (RCF), or augmentation of existing arrangements. Most of this financing carries little or no conditionality, low interest rates and long grace periods. Still, government and external debt burdens will increase for these countries, while progress on structural reform is expected to take a back seat.
Government finances – already deteriorated since GFC – to worsen further
To cushion the blow to economic activity, there will be an increased debt buildup globally, as states, corporates and households see reduced income. Higher fiscal spending is cushioning the blow from the crisis, and this is taking place in both advanced economies and emerging markets. However, emerging markets generally have less shock absorption capacity than advanced economies. They also have less shock absorption capacity than they had during the Global Financial Crisis (GFC). At the time the GFC started, large emerging markets had on average a small budget surplus, while they had a 2% average deficit in 2019. The largest deterioration took place in energy exporting countries, with large fiscal surpluses no longer the norm in countries such as Saudi Arabia and United Arab Emirates. Also, a metals exporter such as Chile moved from a large surplus in 2008 to a sizeable deficit in 2019. As a result, the government debt burden of countries such as Argentina, Chile, Ecuador, Kazakhstan, Romania, Russia and South Africa, more than doubled over the past decade. Still government debt levels remain small in Russia compared to for example Argentina.
In the current crisis year, the average budget deficit is expected to widen compared to the pre-pandemic situation from 3% of GDP to 7%. Countries like Brazil, Egypt, Peru and South Africa are even expected to show a budget deficit that exceeds 10% of GDP. Again, countries that are dependent on commodities are hit more severely. Particularly oil exporters – which are dealing with a halving of the average expected oil price compared to 2019 – are being hit hard. Due to collapsing revenues from commodities production, these countries are seeing on average a further widening of fiscal deficits and increasing public debts. For all of these countries, the oil price will be below the fiscal breakeven price, implying that they will need to either look to their sovereign wealth funds, or get their financing from elsewhere. For many countries in the Middle East this is a continuation of a trend of deteriorating public finances, that has already been going on for a decade or so. While their position remains quite comfortable in many cases, their absorption capacity has fallen compared to the Global Financial Crisis episode. In the current year, government debt burdens are expected to increase sharply again. Thankfully, the majority of the bigger EM countries had a low base, and there the government debt still remains at a manageable level. In contrast, government debt is expected to stay at a (very) high level in countries such as Argentina, Brazil, Colombia, Egypt, Hungary, Lebanon, Malaysia, Poland, South Africa and Ukraine.
For EMs were the corporate sector is deeply exposed to foreign debt, some kind of government bail-outs could be needed. That would increase the government’s contingent liabilities and could lead to a decline in sovereign creditworthiness. This worsening creditworthiness is already reflected in a dramatic number of downgrades by the three big rating agencies, Moody’s, S&P and Fitch. Since the start of the year, a record of 37 countries saw their sovereign rating deteriorate, while only three countries were upgraded. In the last months of 2019, rating upgrades still prevailed. Among the countries downgraded were key EMs such as Argentina, Colombia, India, Mexico, Nigeria and South Africa.
Emerging Asia: China leads post-covid-19 rebound, but external headwinds remain
The covid-19 shock is having a clear growth impact in emerging Asia, although particularly in North Asia (China, South Korea, Taiwan) authorities have succeeded in getting the pandemic under control relatively quickly. The export oriented EM Asian countries have to deal with a collapse in global growth and trade. They are also faced with domestic covid-19 related supply and demand shocks, with tighter financial conditions, the drying up of tourist revenues and/or all kinds of supply chain distortions. For commodity exporters, the drop in commodity prices forms an additional drag. We have cut our growth forecasts for all EM Asian countries, particularly for India (faced with a messy, lengthy lockdown), tourist destinations Thailand and Philippines, oil exporter Malaysia, and trade hubs Singapore and Hong Kong. We expect China to recover in Q2 from the sharp contraction in Q1 (-6.8% yoy), but we have cut our 2020 growth forecast to 2% as external headwinds rise. Taiwan is a positive outlier, as it has been effective in containing covid-19 and is relatively well positioned in high-tech supply chains. We now expect regional growth to fall from 5.1% in 2019 to a multiyear low of 0.5%, followed by an acceleration to around 6.5% in 2021 helped by base effects. This implies that despite the very sharp slowdown this year, emerging Asia will remain a growth outperformer versus other regions. That partly stems from its generally prudent policies that creates room for fiscal and monetary easing in challenging times. That said, we expect emerging Asia to have lost 4.3% of GDP compared to our pre-corona base case by end 2021.
Meanwhile, with economies reopening, China is leading a global industrial rebound. Industrial production was already back to positive annual growth in April. Car production is also recovering sharply, while construction is resilient. Services are also improving, although certain consumer-related services such as catering and transport are lagging. Private consumption and investment are still weak but improving, partly supported by the stepping up of monetary and fiscal stimulus (although Beijing did not adopt an annual growth target, for the first time in 30 years). China’s rebound is also illustrated by the sharp improvement in manufacturing and services PMIs from the February trough. However, for other EM Asian countries, manufacturing PMIs are still far below 50, reflecting the covid-19 induced shocks to external and domestic demand. All Asian export PMIs have shown sharp declines and are still at weak levels. All this illustrates the main risks to our regional outlook: longer than foreseen weakness in global growth and trade and the escalation of US-China tensions in the run-up to US presidential elections, with China’s proposed Hong Kong law adding fuel to the fire.
Latin America: The worst is not over yet
Latin America has been badly hurt by the covid-19 outbreak and seems ill prepared for the consequences. At the start of this year, we expected growth in Latin America to improve from -0.4% in 2019 to 1.3% in 2020. Now we forecast a contraction of almost 8%. The big hit will come in the second quarter. Still, in most countries third quarter growth will remain in negative territory, as the outbreak has not reached a peak yet. Given our global picture we expect a gradual recovery to start in Q4 and a more robust rebound in 2021. Still, for most countries this rebound will not be enough to make up for the average loss in 2020. Important as well is to note that before the outbreak of covid-19, several countries were already in bad shape. The end of the commodity boom in 2014, in combination with adverse political developments led to a slowdown in most countries and to periods of deep recession in Argentina, Brazil and Venezuela. As a result average growth in the region was zero between 2014 and end 2019. Lower growth and lower commodity prices also resulted in a renewed deterioration of the fiscal situation. All of this leaves the region badly prepared to counter the economic consequences of lockdowns and the fallout in global demand and commodity prices.
Argentina was almost uninterrupted in recession since 2016 and, similar to Ecuador, is now trying to renegotiate its government debt. Brazil had also yet to fully recover from the 2015-16 recession. Despite some reform efforts, public debt failed to come down and is expected to rise to 90% of GDP this year. Mexico did reasonably well until last year. In 2019, uncertainty over the course of economic policy of left-wing president Lopez Obrador – who was elected at end-2018 – and trade conflicts with the US led to a contraction of the economy by 0.3%. Chile and Peru saw growth falling significantly as well. The political and social unrest which tormented the Andes countries, including Colombia, in the last quarter of 2019, resulted in a growth slowdown while respective currencies weakened against the USD. Last year’s protests had as overarching themes: public discontent with corruption, public school and health system and economic inequality in general. These protests could easily flare up again, as the severe economic impact of the covid-19 outbreak will only worsen existing structural problems. These issues will continue to temper growth in the medium term as well.
Emerging Europe hit by eurozone, commodity and trade weakness
The growth impact of covid-19 on Emerging Europe is slightly less negative than for Latin America, with an average contraction expected of around 5%. Central and Eastern Europe is being hit by the demand fallout from the eurozone and globally, value chain issues in the manufacturing sector, large-scale capital outflows and the effects of lockdown/ mobility restrictions on domestic demand. Countries with already relatively high budget deficits and government debt, such as Hungary, have less room to increase expenditure in order to counter the downturn than lower debt countries such as the Czech Republic. Energy exporters, such as Russia and Kazakhstan, have been severely hit by low prices of – and low demand for – these commodities. Brent oil is currently at around USD 40 per barrel, which is about 40% lower than at the start of the year. Countries with high sensitivity to capital flow reversals, such as Turkey, have also been hit significantly. This country’s hopes of a robust recovery after the 2018 currency turmoil and near-stagnation in 2019 were squashed. All in all, uncertainty around growth forecasts is very high but a substantial recession is unavoidable in Emerging Europe. In 2021, after the around 5% decrease in 2020 GDP, we expect the region to grow by 3.2%, helped by base effects but hampered by renewed weakness due to consumer caution and second-round effects, such as rising unemployment and bankruptcies. All in all, this will leave the region about 7% weaker at end-2021 compared to the pre-corona scenario, and 2% weaker compared to end-2019.
In search of the most vulnerable EMs using our own risk heatmap
As argued in this publication, the covid-19 outbreak is especially harmful for already heavily indebted commodity exporting countries, and other countries for which growth models are reliant on substantial capital inflows. Countries with large current account deficits that are not covered by foreign direct investment, who have high levels of (external) debt, low FX reserves and low domestic savings are most vulnerable to capital outflow pressures. Political instability and imprudent economic policy can worsen the impact.
Based on the above mentioned criteria we have divided countries into four categories. The ‘very highly vulnerable’ countries (marked red in the table below) are the most fragile, both in terms of creditworthiness and growth, to a deterioration of the global environment. For ‘highly vulnerable’ countries (amber), adverse global conditions will impact the currency and growth prospects, but the risks that this leads to a significant rise in the sovereign default probability is lower. ‘Moderately vulnerable’ countries (yellow) may be impacted by overall negative sentiment towards EMs, but this should be short-lived, while their future growth prospects remain favourable. Here we focus on the bigger EMs (as shown in the table). Many poor heavily indebted (but smaller) countries are already facing debt repayment difficulties and their debt situation has only become more precarious. These countries will rely heavily on multilateral and bilateral support, including debt forgiveness, and would definitely classify as (very) highly vulnerable, but are out of scope of our table.
The external environment has deteriorated strongly post covid-19. Looking back to 2019, only a few countries had current account deficits above 3% of GDP and most had comfortable levels of FX reserves. Now, several commodity exporters have seen their current account deteriorate, although the deficits in most countries are expected to remain modest. More worrisome is the expected further rise in external (corporate) debt. A foreign debt to export (goods, income and services) revenue ratio higher than 2 has long be seen as a level were the likelihood of debt-service problems rise. The number of countries in our table below with levels above 2 has risen from six in 2019 to ten in 2020. All these countries we classify as very highly vulnerable (Argentina, Ecuador, Lebanon, Venezuela) or highly vulnerable (Brazil, Chile, Colombia, Egypt, Indonesia and Turkey). Some countries with debt to export ratios below 2, but high and rising levels of government debt among others, we classify as high risk as well (South Africa, Ukraine). If, for whatever reason, risk aversion flares up again, these are the countries that in our view will suffer most from renewed episodes of capital outflows and currency weakness, which could harm their already weak economic base further.
To conclude, EMs most vulnerable to the broad, deep impact of covid-19 are those that had the weakest preconditions in terms of fiscal and external (including corporate) debt fundamentals when the pandemic struck.