High global (and especially US) interest rates generally drive capital away from emerging markets (EM) as developed markets (DM) investors can realise higher risk-adjusted returns at home, says Mali Chivakul, emerging markets economist at J. Safra Sarasin Sustainable Asset Management.
There is strong empirical evidence that higher US rates and the associated strengthening of the US dollar lead to a tightening in global financial conditions and a decline in cross-border and dollar lending. The sudden reversal of capital flows has repeatedly caused financial crises in EMs. EM external borrowers, both public and private, were usually caught with a depreciating local currency and a weaker economy, limiting their ability to repay their debt in foreign currency.
EM economies have evolved over the years, however. Greater domestic financial market depth as well as increased access and efficiency have allowed major EMs to overcome the so-called ‘original sin’, or a country’s inability to borrow from abroad in its own currency. As a result, they have become less sensitive to US rates and the US dollar as local market borrowing acts as a cushion for these EM borrowers.
Not every EM borrower can borrow in his own currency, however. Smaller firms and lower-income countries with less developed capital markets continue to rely on external borrowing in hard currency. Defaults and financial distress among frontier borrowers are a testament that high US rates are still a binding constraint for less-developed EMs.
Emerging markets resilience
During the latest bout of US rate increases over the last two years, borrowers in major EMs have been remarkably resilient. On the corporate side, there was a clear shift towards local currency issuance. India, Thailand and Brazil accounted for more than two thirds of all local-currency corporate bond issuance since 2022 in EM, according to an International Finance Corporation (IFC) study. The trend towards local currency borrowing was already apparent among Asian corporates even before the pandemic.
The new borrowing pattern has partly shielded these firms from a tightening of global financial conditions. It is therefore not surprising that EM hard currency bond issuance has fallen significantly in the last two years. Issuance picked up again in September when the Fed started its rate-cut cycle.
Default data from S&P indeed suggest that EM corporates have weathered the tightening of global financial conditions in the last two years very well, especially when compared to the 1990s and the global financial crisis period. There has been no default among EM investment-grade bonds since 2016. More recently, for speculative grade bonds, the default rate in EM only exceeded that of global high-yield bonds in 2022.
In 2023, the EM corporate bond default rate at 2.1% was much lower than global high yield’s default rate at 3.7%. The overall default rate of 1% in EM (against 1.9% in global bonds) in 2023 is a good evidence of EM resilience.
Do we expect EM firms to continue to be robust? This will depend on the health of EM firms and the global macro-outlook. Currently, larger EM firms appear financially healthy.
The IFC study, which covers publicly traded companies in EM, finds that interest coverage ratios have returned to a level comparable to the pre-pandemic level despite higher interest payments as a share of total debt. Another study by the International Monetary Fund (IMF) suggests that the share of EM corporate debt with an interest coverage ratio below one has grown over the last two years, implying that there is a growing pocket of firms that are struggling.
The increase is lower for EMs outside China, suggesting that Chinese real estate debt may account for some of the increase. At the aggregate level, EM financial leverage has increased with corporate debt as a share of GDP rising since 2019 in most EMs. Higher debt could make them more vulnerable to external shocks.
A benign global backdrop
While the global backdrop continues to be supportive of EM corporates, there are a number of risks on the horizon. A soft landing in the US (and falling rates), a slight improvement in Europe, and the policy pivot in China are positive for EM. Of course, the elephant in the room is a potential new trade war, to the detriment of global growth and corporate profitability. EMs in particular are vulnerable to tariffs as they usually depend more on trade to grow.
Higher tariffs would add to input costs and reduce firm profitability. The IMF’s recent simulation suggests that a global trade war could lead to a higher share of debt with the interest coverage (ICR) ratio below one.
Indeed, not all EM firms will be affected equally: China, Mexican and Asian manufacturers (Korea, Malaysia, Taiwan, Thailand, and Vietnam) would be impacted the most by a new global trade war, while commodity producers in Latin America are less affected. Tradeable sectors will be more affected than non-tradeable sectors or services sectors.
By Mali Chivakul, emerging markets economist at J. Safra Sarasin Sustainable Asset Management
