Emerging Market: A Thorny Path to Economic Recovery
What does COVID-19 mean for the Emerging Market Bonds and Government Fiscal Stimulus?
Source: The Santiago Times
The economic recovery for the emerging market in Latin America might be longer than the advanced economies. The market possessed weak fiscal health with some countries such as Brazil, Chile and Argentina show signs of debt distressed. The problem exacerbates as the region has been badly affected by the pandemic since May while other regions, especially in Asia, show sign of recovery. This issue encompassing a plethora of economics topics such as economic growth, national debt, and financial stability of the developing countries.
During a recession, government net spending will increase as additional fiscal stimulus is injected in the economy, resulting in additional issuance of government bond. The amount of US$-denominated bonds in the emerging market with a yield above 10% has more than doubled from US$90bn in January to US$190bn (T. Pham, 2020). At this point, investors are raising fears for public debt sustainability and external financial capability. Thus, governments play an essential role to forecast how much spending is necessary to reduce the fluctuation and risk of recession, as failing to do so will amplify the government nominal debt value and face high probabilities of debt default.
Countries that have a high fiscal deficit, poor debt stabilisation, and lower market access constraints are in the spotlight. Economies such as Colombia, Suriname, and Chile pose a high risk of debt distressed and increase the possibility of a sovereign debt default (Fitch Rating). Other governments such as Brazil, Argentina and Ecuador are already negotiating with investors on the restructuring term.
To weather the storm, governments should make a wise decision controlling the inflow of debt and injecting sufficient fiscal spending. Increase in fiscal stimulus through government revenue and bond financing would fundamentally improve the aggregate demand in the economy. The growth could be exponential because of fiscal multipliers that is often implicit. Nevertheless, government should not continue issuing bond to finance fiscal stimulus as it might have negative effect on the economy. According to Kose et al. (2019), the fiscal multipliers in emerging markets and developing economies become negative towards the 90th percentile of government debt as a % of GDP. Thus, thorough policy planning is required to ensure the economy is improving and maintaining satisfactory fiscal health.
Other factors to be consider includes the dollar position, foreign exchange reserve, and commodities index. As investors turn their attention into the Emerging Market region seeking for high yield spread, the combination of strengthening dollar position and low foreign exchange reserve will affect the bond yield and increase the likelihood of debt default. The issue can be further complicate by the poor performance of the commodity market especially in the energy sector. Currently, the oil market is bearish as the expected demand outlook is unconvincing as economic recovery are uncertain with travel restriction and lower consumer confidence level. Mike McGlone, Bloomberg Intelligent analyst forecasted as the industry are facing the threat of supply shock due to the rapid advancement of technology will continue driving the crude oil prices at record low level of $2/MMUBT. Beside supply and demand shock, the contraction of investment at record low level, with company reduce CAPEX to strengthen their balance sheet pose production thread given that demand rise back to the pre-pandemic level. The emerging-market susceptible dependence in the commodity market can further deteriorate the economic growth as the Bloomberg Commodity Spot Index and MSCI Emerging Market are at historically high interdependence with 0.90 10-year annual correlation and both plummeted by 20% to April 30.
To conclude, the pandemic has exacerbated the flaw of debt financing and the importance of good governance in the economy. Moving forward, strong fiscal response and robust balance sheet management will ensure the Latin America economies continue to thrive.