Thematics Views - May 2020

Emerging markets, navigating among several shocks

When we analyse emerging markets in the context of the Covid-19 pandemic, we need to assess not only the impact on growth and the policy mix in place to drive its recovery, but also the vulnerabilities that the same policy mix is breeding, through capital outflows and currency depreciation. The following analysis will help to navigate the different situations in a number of emerging markets, and will offer a more granular country view.

In order to assess where we are with the Covid-19 pandemic and its economic impact on the emerging markets universe, we should firstly highlight the sequence of outbreaks across the world. The first outbreak episode in mainland China in January 2020 was followed by a second outbreak in South Korea and in Western countries (Europe and the US) in the second half of February. Finally, over recent weeks, we have been seeing a sort of third wave that has increasingly impacted the emerging markets and frontier countries. Among the emerging markets, in terms of the infection curve, Turkey, Brazil and Russia seem to be the most affected countries so far, with India and Peru following some way behind (source: Worldometer’s Covid-19 data). However, at this point it is fair to highlight that the death toll is still small in comparison with the situation in Western countries. With regard to this third outbreak, the good news is that emerging markets and frontier countries can heed the early warnings and benefit from the best practices implemented in countries that experienced the pandemic earlier. On the flip side, the bad news is that the healthcare systems in most emerging markets are ill-equipped to handle the kind of severe outbreak seen in the hardest hit countries in the West.

In terms of economic impact, no country will be spared. The combination of a domestic outbreak and the related lockdown measures implemented to contain it (the cure of the disease), together with the external shocks materialising due to weaker demand from abroad and lower tourist flows, will not spare anyone. As we speak, emerging markets are falling into recession, the depth and the length of which will mainly depend on the infection curve, the length of lockdowns and how soon global treatments (accessible to the poorer countries as well) for the virus and/or a vaccine become available. The struggle in terms of domestic demand will be much more widespread in the most open economies, the ones that are well integrated into the global supply chain or are commodity exporters, as well as in smaller economies that are highly dependent on tourism.
Compared to the consensus, Amundi’s emerging market growth forecasts appear slightly less negative for 2020, but weak economic performance is expected to continue for longer, resulting in a U-shape rather than a V-shape recovery with less robust growth levels until 2021. Barring the impact of base effects on next year’s economic growth forecasts, we do expect that economic activity will continue to recover in China and the authorities’ efforts will be focused on putting the country back on track towards the economic moderation envisaged before the crisis.
Overall, emerging market authorities have adopted a much bolder easing mode. At this point in time, the stimulus is still primarily being driven by monetary policy rather than fiscal authorities, with very few exceptions implying a more balanced mix. The role of monetary policy as the leading force in the policy accommodation mix is reflected by the actions of many central banks at unscheduled meetings, as was the case very recently in South Africa, India and Mexico, to name just a few examples. This is even more revealing in the case of Mexico, where the Banxico still has a reputation of being a very orthodox central bank. Among the few exceptions to policy mix being driven by monetary policy, the Bank of Indonesia and the Ministry of Finance recently announced a more coordinated effort to adopt a three-year fiscal plan, which goes well beyond the fiscal deficit’s legal limit of 3% (at 5.1%) in 2020 and is not expected to drop back below the limit before 2023. In our interpretation of the events, at the latest monetary policy meeting, the Bank of Indonesia held steady, favouring macro prudential measures to monetary policy easing as a sign of coordination with a more proactive fiscal authority. A controversial aspect to monitor going forward is the incremental number of emerging market central banks that are adopting quantitative easing and getting ready to buy bonds on the primary market (in some cases amending their constitutions to do so).
In order to reach a more balanced policy mix, we do think that more stimulus should come from the fiscal side.
Having said that, within the EM universe, beyond the direct assessment of the stimulus as being enough to put the different countries back on track, we do have to consider some side effects related to policy easing where there is little policy room and high levels of vulnerability. The combination of recessionary growth rates, a strong USD (or weaker local currencies) and very low oil prices can trigger rating downgrades (which have increased sharply in recent weeks), currency/balance of payments crises and defaults in the worst cases. In order to assess the risks emerging markets are experiencing, we need to evaluate their fiscal fragility and their external vulnerability. As a simple matter of fact, fiscal metrics in 2020 are going to deteriorate due to recessionary growth levels and expansionary fiscal measures implemented to combat the COVID-19 crisis, while at the same time a strong USD or weak local currencies are increasing external vulnerabilities. Combining all these factors, we came up with a stress rank that puts countries like South Africa, Colombia, Hungary and Malaysia as the countries that are more exposed on both sides. Adding the many contingent liabilities to the Central Government’s fiscal position would worsen the ranks of countries such as Mexico and others . The framework presented is going to evolve according to factors that are not easily predictable. In the middle of the crisis we need to monitor the changes to lockdown measures, whether they become stricter or more relaxed, and the subsequent impact on the growth. On the other side, we need to assess the incremental fiscal supportive measures implemented and the resulting deterioration of fiscal metrics. Finally, the advent of a treatment or vaccine could quicken the return to a pre-crisis lifestyle and speed up the economic recovery.

The third risk factor under scrutiny is the exceptionally low oil prices we have seen recently. In an already depressing environment of significant oversupply, a technical incident based mainly on positioning at the time contracts were rolled over from April to May triggered negative oil prices for the first time in history. In our opinion, the latest price movement has less to do with fundamentals and more with technical factors and positioning. Therefore, we expect oil prices to gradually recover to a positive and moderated market fair value with oversupply and falling demand continuing to drive market conditions for some time.
As far as the emerging markets are concerned, we need to firstly discriminate between oil exporters and oil importers. The current environment will continue to favour the second group of countries such as India/Turkey or even China, improving their external positions and decreasing the oil related fiscal costs. However, it will negatively impact Russia, Colombia, Mexico and the Gulf countries.
Having said that, among the oil producers and exporters, there are countries that will suffer more than others if we look at different oil price levels as a fiscal breakeven in the budget or the different costs of production. When we consider this, Russia comes out as better positioned in comparison with most of the Gulf countries.

Fed’s QE: the next phase

The Federal Reserve has bought US Treasuries at an unprecedented pace since it started its QE programme on 16 March. As volatility and liquidity on Treasury markets continue to improve, the Fed is expected to slowly taper its purchases that were aimed at maintaining proper market functioning. However, uncertainty around the extent of the recession the Covid-19 has caused and strong Treasury issuance to fund the fiscal stimulus could discourage the Fed from slowing the pace of purchases too rapidly. In particular, if the supply shock in the Treasury market triggers liquidity tensions, the Fed will increase its pace of purchases. On top of this, the Fed is likely to fine-tune its management of financial conditions with yield curve control (YCC).

Restoring liquidity and smooth bond market functioning with quantitative easing
The Fed launched QE, in its words, to support the smooth functioning of markets for Treasury securities and agency mortgagebacked securities that are central to the flow of credit to households and businesses.
At the peak in late March, the Fed was buying $75bn in Treasuries every day when liquidity deteriorated strongly on the Treasury markets. It has since gradually decreased its purchases of Treasuries, buying only $10bn per day this week. For comparison, the earlier pace of quantitative easing (QE) was $35bn per month during QE1 (Q4 2008 - Q2 2010), then $75bn per month for QE2 (Q4 2010 – Q2 2011), and $45bn per month for QE3 (Q3 2012 – Q4 2014).
Indeed, this unprecedented pace of Treasury purchases has helped stabilise treasury markets. Yields are starting to settle into a range; realised volatility has calmed down; the bid-offer spread has started normalising although it remains wider than before the crisis; and real yields have retreated after their spike, as seen on the graphs below.
It is worth noting that, despite the fact that Fed has been buying Treasuries across the curve, it has focused the largest part of its purchases on the short end of the curve. This highlights that the underlying goal was essentially to address the Treasury market’s liquidity problems. As seen on the graph below, 55% of Treasury purchases planned recently were in the 0-4.5Y maturity range and only 13% in the 20-30Y maturity range. By purchasing Treasuries at the front end of the curve, the Fed has been supporting the markets’ need to raise cash ahead of the coming recession. In a deleveraging context linked to a rise in risk aversion, investors sold short–term Treasuries to fund their cash needs. The large asset purchases also helped free dealer balance sheets from USTs and MBSs, allowing them to pursue more funding intermediation, thereby improving liquidity on the markets. Taking into account the purchases of Treasuries ($1.42bn) and MBS ($268bn), the Fed’s balance sheet has expanded by $1.68tn since 16 March.
So, what’s next?
As liquidity improves, the Fed is expected to move towards a more classic version of QE, consisting of a much lower and regular pace of buying, focused on longer-term maturities to stimulate the economy.
QE will aim to easing financial conditions to support growth and inflation working through two main channels:
- Portfolio balance channel: this works by removing duration risk from the Treasury market, pushing investors to bid up the  value of both remaining longer-term Treasuries and close substitutes such as mortgages and corporate bonds.
- Signalling channel: by signalling policy makers’ intention to keep short rates low for an extended period of time.

Yield curve control could be a useful tool with the prospect of surging government debt issuance at the front end of the curve. YCC could help ensure that frontend rates remain low and stable. Fed Governor Lael Brainard refined its potential use in a advocating for yield curve control as a tool for strengthening the credibility of the forward guidance and as the way to reinforce the Fed’s commitment to maintaining exceptionally accommodative financial conditions. She was considering the possibility of capping interest rates on the short-to-medium segment of the yield curve.³

In this environment, the US Treasury yield curve is expected to be under continuous flattening pressure with short-term rates near the effective lower bound and an increase demand for duration from the Fed. This environment should be supportive for longer-term investment grade corporate bonds.

³Lael Brainard: Monetary policy strategies and tools when inflation and interest rates are low, February 2020