Emerging-Market Debt Outlook 2022

Emerging-market debt face three main challenges in 2022: a reduction in the provision of global liquidity, lower structural growth and contribution to global demand from China, and unsustainable debt levels for some of the more indebted economies.


Recorded on 31 January, 2022.

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Episode Transcript

Note: This transcription was generated using a combination of speech recognition software and human transcribers and may contain errors. As a part of this process, this transcript has also been edited for clarity.


Hello. This is Guillermo Ossés with emerging markets team at Man GLG. Over the next few minutes, I'm going to walk you through the main factors that we believe are going to shape the outlook for emerging markets over the coming months. In our next slide, we see the most important macro factor, in our view, which is the coming massive reduction in the amount of liquidity available globally. The three lines at the bottom of this slide show the evolution of the size of the balance sheets of the Federal Reserve, European Central Bank, and Bank of Japan over the last few years. The yellow line depicts the evolution of the size of the balance sheets of these three central banks put together. And you can observe that between the end of February 2020 and the end of 2021, which is the point in time when the pandemic hits up until the end of last year, the balance sheets of the three central banks grew at an annualised rate of $5 trillion.


Over the next year, the pace growth of this balance sheets, based on what we know the ECB is about to do, assuming that the Fed ends tapering in March, without taking into account further balance sheet contraction and assuming that Bank of Japan will continue managing its balance sheet as it has done over the last 12 months, then for the whole year of 2022, balance sheets are going to grow at only $473 billion annualised. So this $4.5 trillion decrease in the annualised rate of liquidity injection by central banks, it's absolutely massive. Just to give you some perspective, the US corporate high yield market is $1.7 trillion. The whole market cap, not just the flow emerging market countries issue in hard currency between insurance and corporates, seven to $800 billion annually. Stock buybacks in the US equity markets have been, I mean, ranging between $800 and $900 billion annualised.


Hence the decreasing the amount of liquidity injected in the market is going to mean that many asset classes that have grown used to this liquidity supply are about to completely lose it. And it's very difficult to believe that this is not going to have a significant impact on asset prices. Not to mention the fact that the Federal Reserve is very likely to begin a tightening process that would deepen these dynamics. Now, when we focus on the US Treasury market in the next slide, what this means is that there will be a very big distinction between what happened in the first nine months of 2021, which was a period in which asset prices seem to levitate, and what's happening from the beginning of October, when the first debt ceiling arrangement in the US Congress was agreed to by both parties. And you know, how the picture is going to look going forward.


The blue bars in this graph show the net Treasury issuance that ended up in the hands of private market participants. So we're deducting from the Treasury issuance the Fed purchases and essentially accounting for what ended up in the market or hitting the market. In the first nine months of 2021, the net issuance that ended up the hands of market participants was just $101 billion. At the same time, the yellow bars show that every month, due to the fact that the US Treasury spent the very large cash balance that it had deposited at the Federal Reserve, there was an injection of extra liquidity as the Treasury withdrew that money. That is also supportive of asset prices. And it's actually quite similar to what happens when the central bank does quantitative easing.


And in that nine month period from January to September of last year, the liquidity injection was of $1.39 trillion. Now, when in October we had the first debt ceiling brought lower and in late December, we get the final one, the picture going forward changes dramatically because the Treasury is going to have to resume the normal issuance to finance its deficit on the one hand, and on the other, it will also accelerate the issuance to bring its cash balances, which have been depleted to almost zero at the end of December, to the Treasury target of $650 billion. And as a consequence of that, we see that the Treasury will take money out of the economy and deposit it back at the Fed. And these yellow bars show that there will be a liquidity depletion rather than injection as it had happened in the first three quarters of 2021.


So from October of 2021 to the end of 2022, the Treasury is going to perform a net de-issuance after Fed purchases of $1.9 trillion. So we're talking about the average monthly issuance that ends up in market participants' hands going from $11 billion a month in the first three quarters 2021 to $154 billion a month in the following five quarters, while at the same time, the liquidity withdrawal will be of the order of about $430 billion. So we're going from a monthly liquidity injection of $126 billion in the first three quarters of 2021 to a liquidity drain of $28 billion per month in the next five quarters. And it's also quite likely that the Federal Reserve will begin a tightening of the balance sheet that would only force for an additional issuance from the Treasury. And as market participants need to find the liquidity to be able to fund the Treasury needs, asset classes that in the past were substitutes for government bonds are going to be starved from the capital.


Now, there's a second set of factors, if we go to the next slide, which is the structural changes that are being experienced by the Chinese economy. We have heard a lot about what happens in the real estate market, the modifications to the industrial policy in China. And we think that it can be summarized in this slide. If you focus on the chart on the upper right, the blue dots on this graph show the annual rates of GDP growth for South Korea between 1977 and 2007. The yellow dots show investment as a share of GDP in this economy over the same period. In the '70s and for most of the '80s, as South Korea added modern technology to its productive infrastructure, the high productivity of capital on the margin that this new technology brought allow the economy to grow at very high rates that on average were fluctuating around 10% per year.


Now, in every developing story, it comes to a point where the productivity of capital on the margin begins to decrease, once you've saturated the amount of technology that you can add to your economy. And historically, we've seen in many economies that as the economy gets to that point of saturation, policy makers tend to adopt policies that increase investment with the objective of maintaining the high rates of GDP growth. And this is why one could see these yellow dots drifting higher from below 30% in '85, '86 to close to 40% by the early 1990s. And as this abnormally high levels of investment as a share of GDP accumulate, imbalances begin to appear in these economies. And whenever these economies experience an external shock, they are forced to adjust. And we can see that in 1997 on the back of the Asian currency crisis in Thailand and Malaysia, Korea is forced to bring down investment as a share of GDP and GDP growth decelerates from the 10% historical rate that we had seen in the '70s and '80s to around 4 to 5% annualised for the following decade or couple of decades.


We've seen the same phenomenon take place in Japan, which is the chart on the upper left, in the '60s and '70s. The oil crisis in 1973 is what forces policy makers to bring down investment as a share of GDP. And Japan goes to this much slower rate of growth from the mid-'70s on. And in the chart at the bottom, we have the case of China, which has been more extreme than the two cases on top. In the '80s and early '90s, as China adopted more technology, the hyperactivity of capital on the margin allowed them to grow very quickly. But as time went by and that productivity on the margin decreased, policy makers forced the economy to increase its levels of investment. And in 2020, we got the pandemic, which is the external shock that appears to have forced this economy to finally move to a slower rate of growth.


And we think that going forward, this economy is going to grow at roughly half the rate we're used to, just like we've seen in Japan or in Korea. And this will have implication for the rest of emerging market economies in that the demand for what they produce will be much weaker than what it's been in the past. And in the next slide, we can begin to think about the consequences that this will have. The red line on this graph shows the evolution of debt to GDP for the median emerging market country. It's very clear that from the lowest levels of debt to GDP that were recorded right before the financial crisis up until today, that has accumulated quite quickly. Today, half of the emerging market countries have levels of debt to GDP in excess of 60%. The blue line shows those levels of debt for the top quartile of most indebted countries. We see that they're very close to 80 points of GDP.


The decrease in debt that we saw in 2021 was simply a consequence of the fact that in the first half of 2021, inflation accelerated quite significantly in most emerging market countries. Central banks were behind the curve. And the substantially negative real rates that you had helped dilute the stock of that at least partially, but in the last half of 2021, most economies were forced to increase rates quite aggressively. And this will in turn start to push those levels of debt back up. And the two issues associated to what we discussed about China and these levels of debt is that on the one hand, you're going to have lower demand going forward than what it was the case in the previous 10, 15 years for what many emerging market countries produce. And on the other, that this accumulation of debt levels has crowded out the investment. And these countries do not have export sectors dynamic enough to be able to easily adjust. And if you go to the next slide, we can see what the consequences are.



The yellow line in this chart shows the evolution of the average current account balance as a share of GDP for the countries in the emerging markets local bond index. The red one shows the average valuation in real terms for the countries in this index versus the US dollar. In the early 2000s, emerging market economies had low levels of debt. They were growing very, very quickly. And in spite of that, they were running very strong current account surpluses. That allowed for the real exchange rate of these countries to appreciate quite steadily. From 2011, 2012 on, as China began to accelerate, the drop in terms of trade forced an initial contraction in imports, which was made possible by the depreciation of the currencies, particularly, I mean, from 2013 on. And the big current account deficit that these countries had incurred in the mid-2010s was corrected. This led many investors in EM to become quite optimistic for the outlook on emerging market currencies.


Now, what we see here is that both in 2017 and again now in the last two quarters of 2021, as soon as these economies begin to accelerate, due to a lack of investment in the export sector, the export sectors cannot increase their output to the magnitude required to keep the current account balances in equilibrium. And this is in turn why the valuation of the currencies couldn't strengthen and it's indeed at the lowest levels that we've seen since the early 2000s. Now, this also means that in particular those emerging market countries that are among the most indebted are in sort of vicious circle, where they cannot grow quickly enough to stabilize debt to GDP, but if they stimulate via fiscal monetary policy, their current account balances go quickly into imbalances that require the acceleration of the economies.


And this means that it is quite likely that over the coming months, after liquidity is withdrawn from the system or stops coming in the magnitude that it used to, that a lot of these weaker countries are going to get into trouble. And we believe that this is going to push for the final adjustment in many evaluations, and this is what creates challenges and opportunities. So to sum up, if we can go to the next slide, we view an outlook that will be determined by the pace of reduction in the provision of global liquidity and the constraints imposed by the lower structural growth that the Chinese economy is likely to have and the lower demand that EM countries are going to experience in a context that there's a number of countries that have levels of debt that are unsustainable in these conditions. And what this is in essence what will create the problems and what will ultimately generate the new opportunities. Thank you very much for your attention on this webcast. And especially if you have any questions, feel free to contact your relationship managers and let us know.