Are emerging markets the next domino to fall?

In many ways the novel coronavirus is the great leveller, infecting rich and poor alike, indifferent to national borders. It has also sparked a universal challenge for countries: a global shortage in dollar funding. This problem however will hit emerging markets (EMs) much harder than developed ones, and they are likely the next domino to fall in this crisis. In mid-March, those of us who follow the markets noticed something really unusual. In the face of a massive exogenous shock, not only were equities falling—to be expected—but the value of Treasuries, the world’s safe haven asset of choice, was also plummeting. The cause was a massive shortage of US dollars as investors globally liquidated assets to get their hands on cold, hard cash. The US dollar is the global reserve currency—it is the most universally accepted means of payment and store of value. As investors competed to acquire the greenback, its value appreciated relative to most other currencies. Foreign governments and companies conducting a lot of transactions in US dollars saw dramatically increased funding costs and increased costs of hedging their currency exposure. These fluctuations were most obvious in the currency derivative market, where the premiums for cross-currency basis swaps widened significantly, suggesting a spike in demand for dollars. Quick to recognize signs of a dollar funding crisis from 2008, the Federal Reserve intervened swiftly by improving the terms of or opening swap lines with 14 foreign central banks, including Brazil, Mexico and Korea. Swap lines allow foreign central banks to borrow dollars from the Fed in exchange for the equivalent amount in their local currencies, so that the Fed effectively provides dollars to the entire world. The Fed also announced repo operations so that foreign banks holding US Treasuries could park them at the Fed in exchange for dollars. The Fed’s intervention has significantly eased the dollar funding crisis for developed markets, and cross-currency basis swap premiums have fallen. But the pressure is still mounting for a number of emerging markets. This is partly because the Fed’s swap lines have mainly been opened with developed country central banks, though the swap lines eased the pressure on exchange rates in Brazil and South Korea. Emerging market debt is particularly exposed to a US dollar crunch and appreciation because EM sovereigns and increasingly corporates have been issuing significant amounts of debt denominated in US dollars. As the dollar appreciates, these governments and firms have to spend more in their local currency to service ever-dearer debt. And all of this when there has been an excessive build-up of public and private debt in EM, according to the IMF’s Global Financial Stability Report from October 2019. Simultaneously, there have been massive capital outflows from EM. According to the Institute of International Finance, March 2020 was the worst-ever performing month for non-resident capital flows to EM, with USD83bn in outflows. Such violent capital flight pushed up borrowing costs in EM, making debt servicing even more difficult. EM countries are also hit hard by a stronger dollar because so much of their trade is invoiced in US dollars. Around 40 per cent of imports worldwide are invoiced in dollars, even though the US accounts for only about 10 per cent of global sales. Companies like to use dollars because other companies want to use them as well, so it reduces the cost of doing business. But as the dollar appreciates, imports invoiced in the currency become more expensive for EM countries. And all of this has occurred against a backdrop of collapsing oil prices. This has been partly a demand issue as most major economies have been shut down in response to the coronavirus pandemic. But it has also been driven by supply as Saudi Arabia and Russia agreed to flood the market with oil, sending Brent oil prices all the way down to USD 25 per barrel at one point. A number of EM countries including Mexico, Colombia, Nigeria and Angola are reliant on oil for revenues and as a major source of US dollars. The shutdown of the global economy also truncates revenues for EM countries in other ways. Some EMs are heavily reliant on tourism and remittances. Tourism accounts for 12 per cent of Thailand’s economic output and 34 per cent of Jamaica’s. A diaspora of workers in developed countries sending home part of their paychecks have now lost their jobs. Remittances account for 20 per cent of El Salvador’s GDP and 10 per cent of the Philippines’. Emerging market countries have far fewer macroeconomic tools to cushion these blows than developed economies. They have less money to spend on fiscal packages to support workers and companies through the pandemic, they have weaker social security nets and it is more difficult for their governments to borrow money as borrowing costs soar. Central banks are unable to fire up their printing presses without stoking fears of a return to previous episodes of inflation, and doing so weakens their currencies further relative to the US dollar. And none of this takes into account the health crisis that has not yet fully hit most of EM (excluding China). Social distancing is far harder to do in the slums of Johannesburg than it is on the banks of the Charles River in Cambridge, Massachusetts where I am sitting. EM health systems are even less prepared to handle a surge in new Covid-19 cases than developed economies. If EM is the next domino to fall, this has implications for the rest of the world. The US and Europe are largely under lockdown to slow the spread of the virus. But as they succeed in doing so and economic behavior slowly moves back towards normalcy, EM will still be in the throes of the challenges I have outlined here. This means that a globally-synchronised, V-shaped recovery is realistically not on the cards.