Emerging market resilience is waning rapidly.
When America sneezes, emerging markets (EMs) catch a cold. This depiction proved true in 1993 and 2013, and it continues to hold today. As the Federal Reserve and other major central banks tighten their monetary policy stances to combat inflation, emerging economies are being placed under pressure.
This year has seen much higher government bond yields and volatility in financial markets. This has led to capital flight towards the U.S., creating a sharp appreciation in the value of the dollar. These factors contributed to a fierce sell-off in emerging market assets, with the average yield on EM local-currency bonds rising to the highest level since June 2015.
The pain is not just in financial markets. Inflation is a bigger headache to EM households than it is to those in higher-income countries. Consumers in developing economies, on average, pay a far bigger chunk of their incomes for essentials like food and energy, the most disrupted categories of the past year. Rising costs for these essentials (a good portion of which are imported) serve as an impediment on discretionary spending, hindering growth.
Higher commodity prices have boosted terms of trade for EMs that are exporters, leading to stronger current account and fiscal positions. But not all are benefitting. Countries heavily dependent on imports of essentials have seen the biggest rise in inflation and the largest deterioration in external and fiscal positions.
"The pandemic has slowed the pace of economic convergence between the advanced and emerging worlds."
The slowdown in western demand centers is only adding to the stress. The cost-of-living crisis coupled with withdrawal of easy money is pushing major economies into a slowdown or downturn. With many developed nations likely to be in mild recession early next year, trade and tourism won’t be of much help in to emerging markets in 2023. China’s slowdown is another area of concern, especially for Asian economies like Taiwan, Singapore, and Vietnam. Slower production will ripple through to resource-rich nations such as Brazil and Chile as their trade flows to China diminish.
EMs were more resilient before the pandemic, with increased reserves and smaller trade deficits, but those buffers look increasingly stretched. Many had already exhausted their financial resources in dealing with the pandemic. Several nations are burning through large amounts of foreign exchange reserves to prop up their currencies amid capital outflows. The stronger greenback is raising the cost of their debt, which is increasingly becoming dollar-denominated and of shorter duration. Trade deficits are widening, owing to higher import prices and softening exports. As a result, many low-income countries are already in or close to financial distress. A widening debt crisis in emerging economies could easily precipitate a global recession.
While most EMs are simply caught in the global tide, others are suffering due to their own mistakes. Turkey’s unorthodox and misguided policies have sent inflation soaring and their currency into a free fall. Pakistan, which has knocked at the International Monetary Fund’s door 20 times, has long avoided essential fiscal and energy reforms. Argentina is a serial debt defaulter, refusing to learn from its mistakes.
The dollar is expected to remain strong well into 2023, causing a sustained threat to economies and financial conditions. EMs are facing another year of difficult choices, balancing their efforts to support growth with restoring price and fiscal stability. Some will continue to grow while others will falter; but all will likely perform below potential.
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