The emerging storm

It is no secret that, during times of crisis, there is a flight to safety from emerging markets to perceived safer havens, such as the US. Foreign investment outflows from emerging market bonds and shares are in the region of US$100 billion since January. Capital is flowing out of some of the countries that need it most, at a time when they needed it most. Why? Because the risk premium (i.e. the level of return expected due to the increased risk associated with these investments) cannot be quantified.

This, along with other factors, such as tourists not requiring local currency to enjoy local goods, and a slump in exports, puts downward pressure on emerging market currencies. For instance, the Russian rouble and Mexican peso have depreciated 20% versus the US dollar, which could lead to inflation in these countries.  In countries where the currency is pegged to the US dollar, this has resulted in decreasing international reserves, as central banks have had to intervene on foreign exchange or sovereign debt markets. The Federal Reserve’s swap lines to 14 central banks (South Korea, Brazil and Mexico among others) have prevented a global dollar shortage.

Commodity prices have collapsed. Many of these countries are large producers of commodities, which the rest of the world needs to manufacture goods. That need has dried up. We recently covered the collapse of oil prices, but this deserves another look using the Middle East to illustrate the variance of reliance on liquid gold, even within the same region.

In Iraq, the whole country is affected at the most basic level: oil is the biggest source of wealth in a nation where there is limited social security and which is already in the midst of a humanitarian disaster because of the war, with displaced people living in camps.

The Gulf, which is perhaps of more interest to western investors, is able to better withstand a drop in oil prices on a short-term basis, but long term this represents an existential crisis. The Cooperation Council for the Arab States (which used to be known as the Gulf Cooperation Council or GCC) economies operate on a high oil price. Their break-even point to cover the cost of government and financial obligations to their populations range between US$44 and US$108 a barrel, with the average sitting at around US$80. There has been an effort to bring this reliance down, by diversifying economies and reducing employment in the public sector, but they are far away from achieving these goals.

The COVID-19 pandemic also sets them back because some of the industries they are diversifying into are heavy industries or tourism, which have been completely destroyed. Worldwide trade has been severely damaged by the pandemic and travel has completely stopped. When export levels fall, countries typically bridge the gap between these and their imports by borrowing from other countries. But now these countries face higher borrowing costs, because they represent a higher risk. Emerging economies may need at least US$2.5 trillion to combat the effects of the pandemic, either from foreign sources or their own reserves. As a response, the G20 group has granted a period of grace in debt servicing arrangements for the world’s poorest 77 countries, but private investors have yet to do the same.

The Middle East also serves to highlight another headwind prevalent in both emerging and developed markets – that of pre-existing political tensions. When the pandemic first broke out, the UN’s Secretary General, Antόnio Guterres, called for peace, saying “The fury of the virus illustrates the folly of war” and the world appeared to listen. But sadly, while some factions have announced a ceasefire, the pandemic could exacerbate tensions between or within societies, or be used for political manoeuvring, especially when the most powerful job in the world is up for grabs this year.

The tensions between the US and China over the origins of the virus and the role of the World Health Organization perfectly illustrate this point and the dangers these pose, not only to economic prosperity, but also to peace. Other nations will argue about access to health services or jobs. One only has to look at the 2014 Ebola outbreak in Africa.  Tensions can create a vicious circle that leads to even greater fragility in poorer nations. We have all seen footage of protests in Iran, Iraq, Lebanon and Venezuela, all of which were already in the middle of economic and humanitarian crises. In these countries, the pandemic is having the effect of suppressing political dissent. On a human rights level, this is very concerning: it is giving authoritarian governments a lot of power to do whatever they want without a populous push back.

Fiscal and monetary manoeuvring is more difficult. Emerging market economies have limited space for increased spending. Many emerging economies may be forced to take a “whatever it takes” approach, despite their budget constraints, and non-internationalised currencies. In many cases they will face policy trade-offs. For example, central banks will buy government bonds to provide financial lifelines that support smaller firms and households. Alternatively, central banks can use their balance sheets more flexibly to support bank lending to small and medium-sized companies through risk sharing with the government. Most emerging market nations, in particular in Africa and Latin America, have limited room in their budgets to increase to the spending necessary to control the spread of the disease and prop up their economies. Tighter global financial conditions limit access to finance, and development projects will suffer substantial delays or won’t get off the ground. For countries with flexible exchange rate regimes, the exchange rate should be allowed to act as a shock absorber.

The UN has warned that over 1.6 billion people work in the informal economy – part of the economy that is neither taxed nor monitored by any government – and most of these are in emerging markets, although that is not always the case, as we have seen in southern Italy. Here, if you don’t work you simply don’t get paid. The informality of this economy makes understanding and helping the needs of the most vulnerable an even greater task. It is estimated that in the first month of the crisis, the income of informal workers fell 60% globally and by over 80% in Latin America and Africa. Because this economy is informal, governments might be unable to reach vulnerable households through traditional transfers, and particularly where there are no extensive social assistance systems already in place. The informality rate in Latin America is close to 40%, compared to 10% in advanced economies. Countries will need to create fiscal space in their budgets by reducing non-priority expenditure and increasing the efficiency of spending.

Added to this, many of these economies were already on the edge of a precipice, with significant reliance on humanitarian aid, which is drying up to compound the problem, and charitable organisations are crying out for additional funding. Not only this, delivery of aid is hampered by restrictions on movement of people.