By Robin Marshall, Director, Fixed Income
Concerns about a wave of EM defaults has recently emerged
Some commentators have expressed concern about a wave of Emerging Market (EM) debt defaults, based on the scale of the Covid-19 shock, declines in commodity prices, the expansion in EM debt since the GFC, the strong US dollar and inadequate public health systems. Recent credit spread widening, particularly in EM dollar debt, reflects these fears. Chart 1 shows the spread widening has been substantial in US dollar EM, even after recent narrowing on IMF policy proposals. Lower credit spreads on EM local currency debt are explained by the fact EM sovereigns (just like G7 governments) can print money, or raise taxes, to repay their local currency sovereign debt. In contrast, the US dollar debt creates a currency mismatch between their assets and liabilities. Therefore, default rates in local currency debt are lower, which is reflected in credit ratings*.
Emerging Market credit spreads versus US Treasuries
Source: FTSE Russell. Data as of April 28, 2020.
Default concern is concentrated on EM dollar debt and because Covid-19 is a global shock
The EM fixed income asset class also escaped contagion in recent years and actual default rates were lower than predicted in the GFC, partly because EM economies grew by 3% in 2009, benefiting from spillover effects from G7 QE. But the Covid-19 shock is global, so risks to EM economies are higher in 2020/21. The IMF’s baseline forecast is that EM economies will contract by 1% in 2020 but achieve 6.6% growth in 2021 (April 2020 forecasts). A 2020 contraction, and failure of the V-shaped recovery to materialize, would be a much bigger challenge for EM debt solvency arithmetic, particularly if developed economies switch demand away from global supply chains, rooted in EM economies.
Credit spreads imply much higher default rates than those seen historically
Default probabilities can be approximated from credit spreads; assuming a recovery rate of 40%, credit spreads of about 700bp in US dollar debt, reached in the early stages of the Covid-19 shock in March, would imply a default rate of about 16% (depending on the liquidity premium in credit spreads). Current spreads nearer 600bp would imply a default rate of about 10%. Chart 2 shows these would be high default rates historically, which may reflect the scale of the economic and financial shock (note that after a sovereign default on one bond, the FTSE EMUSDGBI Extended Index assumes all its issues are in default).
EM$ (USD) Sovereign Debt Default Rate
Source: FTSE Russell. Data as of March 31, 2020.
But failure of a V-shaped recovery to emerge in 2021 is main risk
Because this is a global shock, and not an EM specific event, a global policy response has resulted. The US Fed and ECB have broadened their QE purchases, and the US has approved a fiscal stimulus of about 9% of GDP, and an extended US dollar swap facility to ease global dollar liquidity (March 2020). The IMF enters the crisis able to lend an extra $1 trillion compared with $250bn before the GFC (IMF, April 9), and has expanded the Rapid Credit Facility and Financing Instruments by an initial $100bn. The GFC was followed by a $500 billion increase in the IMF’s Special Drawing Rights allocations, in 2009, and although a further increase is not yet agreed, the G20 has agreed to freeze bilateral government loan repayments for lower income nations, until the end of 2020 (from May 1). These policy responses do not remove solvency risks from EM sovereigns but help ease financial conditions globally. Failure of a V-shaped recovery to occur in 2020/21 seems the main risk.
* The credit rating of the FTSE Russell Emerging Market (local currency) government bond index is A-, compared to BBB- for the FTSE Russell (USD) Govt. Bond index.
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