The Spring Meetings of the Boards of Governors of the World Bank Group and the International Monetary Fund (IMF) bring together central bankers, ministers of finance and development, private sector executives, academics and many others to discuss a variety of issues, economic and social. Mike Hugman and Werner Gey van Pittius were there. Here is their summary of the key takeaways for emerging market debt investors.
The global backdrop through the eyes of senior officials
Populism and protectionism continue to rise
Despite recent indications of growth bottoming, many policy-makers remain worried that a widespread lack of sustainable growth may continue to foster populism and nationalist trade policy and could lead to the erosion of central bank independence.
A scarcity of growth is creating competition between countries in the form of barriers to trade and investment. It is also leading to significant imbalances in the distribution of wealth within countries. As we wrote only recently, weak economic growth can translate relatively quickly into fiscal challenges and then political unrest – this is an all-too-familiar pattern in emerging markets that can easily catch out investors.
As for China’s economic outlook, investors and officials seemed generally relaxed as stimulus measures are gaining traction without being excessive or unsustainable. There was surprisingly little discussion about China’s expansion in global capital markets – something that we see as a key step in the move to the mainstream of Chinese assets.
China’s stimulus measures are considered both measured and effective.
The mood around US-China trade relations was relatively positive, even if officials believe that any deal will be rather short-term in nature. In contrast, senior officials voiced concerns over the potential for tariffs on the auto sector. Tensions in Europe arising from France’s desire to protect agriculture and Germany’s aim to protect its auto industry are seen as weakening Europe’s ability to negotiate. Some are also worried that the United States-Mexico-Canada Agreement may also not pass.
In summary, trade matters seem set to continue to keep the various Washington delegates awake at night for the foreseeable future.
Central bank independence faces continued threats
A key topic in Washington was the impact of extraordinary central bank policy that has followed the global financial crisis. This has had a huge impact on wealth distribution. As monetary policy has turned out to be more effective at stabilising markets than at influencing inflation, it is hardly surprising that central banks have become politicised.
What next for the US dollar?
The US has seen a regime change away from technocrats but the market does not seem to be overly concerned by this at present. And as is often the case with some of these more subtle structural changes, it will likely take a long time for the market to price in a higher term premium.
A weaker dollar could lead to an EM bull run.
One topic that has proved a conundrum for the parties gathering in Washington is why the dovish pivot of the Fed has not provided more support for emerging market currencies. Various reasons mooted for the stubborn strength of the dollar include its possible current status as a relatively high yielding petrocurrency and the view that the dovish Fed is symptomatic of a broader package of nationalist policies in the US, many others of which are generally hampering emerging markets. A shift in consensus to an expectation of Fed rate cuts would outweigh both factors to boost emerging market assets. A weaker dollar could lead to an EM bull run.
Of course, these considerations are short-medium term in nature. We would encourage investors to also consider the longer-term trajectory for the dollar, a topic we have recently analysed in depth.
While the Fed’s dovish shift, improving Chinese growth prospects and the expectation that negative rates will persist in Europe have all boosted inflows, EM debt investors’ current positioning is still skewed towards hard currency debt, with emerging EM FX positions only slightly long at present as reflected in our proprietary beta trackers. However, consensus is shifting from high yield credit to FX.
Momentum appears strong over the short-term as asset allocators respond to what appears to the end of the developed market tightening cycle. If the US dollar were to start slipping against the euro and renminbi, then global financial conditions could help to extend this EM performance through the year. And while Asia has lagged so far this year, it could be the region that benefits the most from the end of the developed market tightening cycle over the medium-term.
Momentum for EM assets appears strong.
From a longer-term perspective and consistent with our view that emerging market assets are moving to the mainstream, asset owners and global bond investors seem to be embracing emerging markets, with hard currency debt currently favoured.
Investors rightly point out that the growth and central bank independence dilemma extends to emerging markets. In many high yield emerging markets, improved inflation and current account stability have been achieved by monetary and/or fiscal tightening. This has left growth rates very low and may not be sustainable fiscally or politically over the long run, as mentioned above. In countries like South Africa and Mexico, it is not clear that the level of interest rates required to anchor financial stability via the currency is also consistent with getting GDP growth back up to potential. A weaker US dollar would solve this dilemma, but if this does not materialise then we would need to see growth-enhancing structural reforms or pressure will build on central banks to ease. Selectivity will be key.
In emerging credit markets, investors broadly expect further divergence and strong active management opportunities. A wide range of countries are borrowing from some combination of the IMF, China and the Gulf Cooperation Council. This can create moral hazard, as mentioned below, and investors need to focus on those countries where there is social-political appetite to run primary surpluses.
In EM credit investors expect further divergence and strong active management opportunities
Commodity markets, including oil, are expected to remain reasonably tight in the short-term, but Trump has levers to try and push oil lower later in the year, such as pressuring Saudi Arabia with the threat of NOPEC legislation.
Our take on individual emerging markets
Here’s our take on how individual countries/regions fared in Washington.
Top of the class
Strong presentations from the finance ministry and central bank, but rating agencies were clear that the upgrade cycle will be a long process and while investors are positive in theory, in practice they are still waiting for a real catalyst to add positions.
Strong IMF support with a well-designed programme, lots of flexibility. Growth model transformation is highly ambitious, but Ecuador should be able to make a decent start. Politics will be challenging as steps like subsidy removal will be painful, but opposition is centre right and supportive of this package.
Goodwill from the IMF, there is low hanging fruit which could get the debt/GDP ratio moving down, although contingent on President Bukele getting the right team and working with opposition. The incentives are ultimately there for cooperation, despite political noise.
Also goodwill from the IMF, relying on the continuity of the Parliamentary government, although the Enrichment law needs to be successfully recast after the Constitutional court struck it down.
From a credit ratings perspective, general impression that regional credit rating picture is solid, and currencies have lagged due to China and EUR weakness, and this could turn in coming months.
Both countries delivering 4% growth with healthy levels of investment, but latest inflation data suggests bigger output gap and more room for rates to stay on hold, so nice macroeconomic mixture.
Still working hard to bring down headline deficit despite hitting primary target. President has committed to IMF to have a new programme, and Euroclear MoU signed for local bonds.
Central bank remains very solid, with a clear reaction function but including adjustment for global risks and current account deficit, will remain somewhat on the hawkish side to provide an anchor.
Central bank presented as quite hawkish on both inflation and financial sector risks relative to prior expectations that there had been more political capture.
IMF has asked the country to slow down the pace of reforms, e.g. not remove subsidies too fast. Also, central bank governor was talking up a faster liberalisation of the capital account, again the IMF were (i) surprised and (ii) actually don’t want things to move too fast. But clearly no reform fatigue.
Continues to pursue long-term policy of total insulation from global flows and US financial sanctions, but new fiscal expansion may be challenging to absorb, and more sanctions are coming in the short-term related to Chemical weapons. There is further risk in the summer if Russian oil services firms go into Venezuela as the US firms are forced to leave in June under the sanctions programme.
Minister continues to underpin confidence, but IMF appears concerned that further fiscal gains are going to be hard and debt stability not clearly a baseline.
Fiscal message remains solid, and more conciliatory towards investors. But hazy still on infrastructure and PEMEX plans. Central bank increasingly split, but hawks holding their ground for now.
IMF very positive and usual strong presentations, short-term US dollar supply seems to be widely accepted now. But political analysts becoming more concerned/confused about the election risk.
Reasonably reassuring on the ability to achieve new, looser, fiscal goals, but weak response on current account deficit, possibly too complacent given success on getting current inflation down.
Central bank struggled to explain its most recent shift back to a more dovish/opaque monetary policy setting despite higher core inflation.
Representatives of new government presented a positive, ambitious outlook. But legal discussions highlight the unprecedented complexity of this debt workout. Furthermore, the US is now looking to completely collapse oil output with a view to forcing Maduro out even if this takes multiple quarters to achieve and first has to precipitate a complete economic implosion.
Also struggling to explain policy in an environment of a widening current account deficit, not wholly convincing on the point that it is private rather than public demand that is weakening external balances.
Finance Ministry not able to fully explain revenue shortfall and material bank recap costs also on the horizon. Will test improved institutions e.g. fiscal council in election cycle. But growth model does continue to diversify.
The central bank continues to command tremendous respect and act as an anchor, but concerns are growing about the absolute lack of growth.
Should try harder
Lack of urgency on fiscal adjustment or IMF programme. No urgency to really rationalise and account for Chinese borrowing. Some positive steps on diversifying energy supply, but confused message on building reserve buffers.
Minister of Finance was evasive about any structural or cyclical policy improvements, or any concrete way to raise resilience to short and medium-term shocks.
Imbalances on a magnitude of Egypt in 2015, but with a political environment/electoral cycle which appears to make any effective response impossible in the short-term. IMF clearly struggling to formulate an effective programme. Plan B is to hope the Gulf Cooperation Council bails out the country.
Frontier markets getting bail-outs without strong IMF programmes
Longer-term, there is increasing discussion about how we ended up with so many frontier economies back having to be bailed out by some combination of the IMF, China and Saudi Arabia/Gulf Cooperation Council.
It has taken 15 years since the IMF’s Heavily Indebted Poor Countries initiative to completely undo debt relief. IMF staff appear resigned to a very complex and unsatisfactory relationship with countries like Lebanon and Pakistan, where the presence of Chinese and Gulf Cooperation Council money is eroding incentives to achieve tough reforms and creating moral hazard over the long run.
Jeromin Zettelmeyer has become Deputy Head of the IMF’s fiscal department and he is a strong proponent of large private sector restructuring to bail-in countries, so the IMF could get tougher in unsustainable debt cases.
Emerging market (inc. China): These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.