Emerging Markets at the Cusp: Part One-The Past as Prologue

This article is the first of a series about the challenging global environment facing Emerging Markets/Developing Countries (EM/DCs) living with the legacy of the pandemic and the Ukraine war. In this series, we want to apply the techniques of Country Risk Analysis to assess the changing risk environment, especially as it applies to a potential debt crisis.  

The first article, The Past as Prologue, focuses on the parallels between the first major debt crisis of the 1980s and the situation today. The second one, Emerging Markets and Global Risks, deals with the challenging environment facing the EM/DCs.  The final one, Emerging Markets Debt: Crisis or Resolution?, will analyze the risks of another global debt crisis affecting EM/DCs.

The Past as Prologue

The past is a foreign country; they do things differently there.

L.P. Hartley

In the late 1970s and early 1980s, the global economy was facing turmoil.  The 1970s had seen soaring inflation, a quadrupling of oil prices and economic stagnation.  Surging petrodollars had been recycled in ballooning lending to the so-called less developed economies (LDC) —oil exporters and importers alike—in the form of syndicated loans. The decade had ended with a major international crisis, the Iranian revolution, followed by the bloody Iran-Iraq war, both events upending the geopolitical map of the oil-rich Persian Gulf and sending oil prices soaring.  Enter Paul Volcker, the newly appointed Fed chair, who engineered a brutal tightening of US monetary policy, raising the Fed funds rate to almost 20% and triggering two successive US recessions in 1980 and 1982.  The global recession, the ensuing fall in commodity prices, combined with soaring interest rates led to wholesale defaults of the LDC debt—the so-called Latin American debt crisis, which was really a global one-followed by a decade of repeated LDC debt restructurings in the framework of tough multilateral and bilateral financial support programs.  

Today, we face a situation with many similarities:  a global economic slowdown that could herald a recession; high inflation and the threat of stagflation; surging energy and commodity prices; an ongoing tightening of monetary policy in the major advanced countries (AEs) leading to sharply higher interest rates.  Furthermore, we are seeing several EM/DCs debt at highly distressed levels, with already some cases of default (Sri Lanka) and near-default (Pakistan).

Fed Funds Rate and Inflation1978-1984

Fed Funds Rate 2020-2022

Does this mean that we are facing another debt crisis? Where do the similarities between then and now end?

In the first place, the global debt landscape was much simpler then.  The debtors were almost exclusively sovereign governments or state-owned enterprises; the debts were almost exclusively bank loans denominated in major currencies (mostly dollars.  Negotiations between debtors and creditors were organized in a collective framework in order for the purpose of negotiation with debtor countries. This was done to prevent individual countries from trying to get special advantages by going it alone. Private creditors, the major Western and Japanese banks, were organized in the so-called London Club. Official bilateral lenders---the governments of the advanced economies (AE), were organized in the Paris Club framework.  Finally, you had the multilateral financial institutions—The IMF, the World Bank and other multilateral regional development banks, who provided both financing and analytics. 

The 1980s LDC debt crisis did not end until the late 1980s. Despite repeated reschedulings and reschedulings of reschedulings, new financial packages and a series of painful so-called structural reform programs, the problem was not resolved until the late 1980s with the introduction of significant debt relief under the Brady Plan--named after Nicholas Brady, the8U.S. Secretary of Treasury who initiated the program--which replaced existing debts at a deep discount with the so-called Brady Bonds.

The situation stabilized in the 1990s. We started talking about “Emerging Markets” (EMs), a term designating the largest and most advanced LDCs. Nevertheless, the situation remained volatile, and the 1990s and 2000s were punctuated by several global financial crises.  With one exception (the 2008 Global Financial Crisis), these affected mostly what have been called Less Developed Countries (LDCs), Emerging Markets/Low Income Countries (EM/LIC) and Newly Industrial Countries (NICs): The “Tequila” Crisis of 1992, the Asian Crisis of 1997 and the Russian Crisis of 1999.  

Box: Emerging Markets/Low Income Countries (EM/LIC).

There are a number of different classifications and definitions for EMs.  The IMF classifies 39 countries as EMs.  While the EMs are formed of a diverse group of countries, they share a number of characteristics:

• Middle Income
• A good economic policy track record
• Sustained access to global financial markets
• Greater global relevance in terms of GDP, trade volume and integration in the global manufacturing and supply chains.
• Generally rated as investment grade by the major rating agencies

The IMF classified another 117 countries as Low Income (LIC) or Developing Countries (DC).  As we will see, the distinction between EMs and LICs will be important in terms of our analysis.

While each of these events had different roots and different consequences, they had a common root: sustainability.  A quote attributed to the economist Robert Gordon:"if things are not sustainable, they stop".  Essentially, just a like a financially-strapped household has to make a choice between paying its electricity bill or buying food, countries have to make a similar decision of paying for essential imports or servicing its external debt.

There was significant changes in the  global financial environment facing the EMs and LICs in the past decades:

Policy frameworks are more robust. Structural changes and economic reforms have increased the resilience of the Emerging Markets (as well as that of the LICs). In particular, EMs have significantly higher levels of international reserves, as well as greater access to financial markets.

In the 1970s, creditors of LDCs were exclusively the major international banks and advanced countries governments.  The debtors were exclusively governments or government-owned entities, and the debt was exclusively foreign currency-denominated debt to foreign banks and bilateral and multilateral lenders. Since the 1990s, there have been major changes on both sides of the EM balance sheets.  On the creditor side, EMs have had access to a broad variety of finance and financial instruments. On the debtor side, EM corporates and financial institutions form a large portion of the countries liabilities.

• The EMs benefit from much financial cushion in the shape of international reserves, which reached n estimated $4.3 trillion at the end of the first quarter of 2021
• Global financial markets have expanded significantly and global financial markets have been liberalized.  This has resulted in a greater diversity of and greater access to capital flows
• The EMs have benefitted from two decades of financial innovations, low interest rates and inflation, loose monetary policies in the AEs and a burgeoning global savings glut.
• Sources of finance have expanded with new players, in particular from China and cash-rich oil producers of the Persian Gulf.
• While oil prices have surges in the past few months, the world economy is less dependent on oil and gas

Nevertheless, while the EMs/LICs emerged relatively unscathed from the 2008 Financial Crisis and Great Recession, the pandemic and its aftermath and the Ukraine War has left them facing a perfect storm of a slowing global economy, inflation, higher interest rates, surging commodity prices and high levels of indebtedness.  It is nevertheless important to note that these factors have affected EMs and LICs differentially, and the remedies in each case will be different. 

The next section of this series will focus on the challenges facing the global economy, and in particular on their impact on the risk environment facing EMS/LICs.