Debt and currency crises in emerging countries tend to surface when the Federal Reserve raises interest rates. Their debt is more vulnerable than that of developed countries because they are less capitalized, have less diversified sources of financing, less stable inflation rates, and are less easily convertible into debt.
In the emerging world, sovereign risk is rising as economies recover, as is sovereign default risk. Emerging market currencies tend not to be convertible, which makes its issues are relatively illiquid and makes it difficult to sell bonds by governments as a hedge against default.
It is likely that credit conditions in emerging markets deteriorate given persistent inflationary pressures, tighter financial conditions, slower growth in China and a possible recession in the United States.
Thus, funding costs for emerging market issuers are rising rapidly, with conditions expected to continue to worsen as the Federal Reserve ramps up its efforts to rein in inflation and most emerging market central banks continue to act. Yield spreads on emerging junk bonds are in the territory of all-time highs seen in the covid crisis or the Great Crisis.
For emerging countries, access to credit markets in recent quarters has been limited, and lower-rated issuers have difficulty refinancing their debt. Domestic capital markets and bank financing are viable alternatives for smaller issues, but are subject to shorter maturities and higher financing costs.
To this, we must add the starting point. And it is that they are still dealing with the consequences of the pandemic, which increased debt burden and fiscal pressures. For emerging markets, sustaining economic growth, while containing fiscal trajectories and possible inflation-related social reactions, will be critical in the coming quarters.
Following in the footsteps of the Federal Reserve to save its debt
If we go back in time, most central banks in emerging markets, with the exception of emerging markets in Asia, where inflationary pressures have subsided until early 2022, rates were already rising before the Fed took offso domestic financial conditions had tightened.
Recently, risk aversion has prevailed, external financing conditions have strengthened and emerging market currencies have fallen sharply against the dollar. And there is no way to escape from the Fed’s hand, the central banks of emerging countries must follow the path marked out in the coming months to avoid the worst consequences.
The first of all: capitals are fleeing emerging. Cross-border outflows by international investors in emerging market stocks and domestic bonds reached $10.5 billion in July, up from $38 billion. This marks the longest period of net outflows since records began in 2005.
Exits risk exacerbating growing financial crises in developing economies. Sri Lanka has defaulted on its sovereign debt in the past three months, and both Bangladesh and Pakistan have turned to the International Monetary Fund for help.. A growing number of other issuers in emerging markets are also at risk.
We have countries in the crosshairs. This is the case in Chile, Poland, India, the Philippines and Thailand.whose current account deficits are likely to come under pressure from persistently high energy prices in coming quarters that more than offset food trade surpluses in some of these countries.
Many emerging central banks now face the choice of tightening further to cap price pressures (but dragging down growth) or letting their currencies fall further (but importing more inflation). Especially, it should be noted to Turkey that although it does not enter the previous list it could enter shortly.
Turkey starts from a current account surplus basis, that is its strong point, but government moves to support the lira while refusing to raise interest rates—in effect, promising to pay local depositors the cost of depreciation of the currency for maintaining the currency—have a high fiscal cost for the country. If its situation were reversed and it reached a current account deficit, the need for external financing would lead the country to collapse.