Emerging Markets & COVID-19

How Things Look Now

April 30, 2020 – Emerging markets are suffering two sudden stops, in economic activity and in capital flows, but only one of them is ‘unprecedented’. As far as capital flows are concerned, the news is bad but not catastrophic, and risk appetite towards EM seems higher today than it did at the same point of the Global Financial Crisis. This partial recovery in risk appetite is good news, since it makes two unpleasant outcomes — capital controls or the need for IMF support — less likely. Aside from the improvement in global risk appetite that has resulted from core central bank policy activism, three factors are helping emerging market capital accounts: (1) the improvement in current account balances, (2) the monetary space being created by collapsing inflation, and (3) the fact that low inflation allows real exchange rates to weaken more efficiently.

The collapse in emerging market inflation will give central banks more scope for easing, which they are under an obligation to do to ease the pain for domestic firms and households. We think emerging markets might see rate cuts in the coming months that, by normal standards, might seem shockingly low. Low inflation also creates space for central banks to conduct more non-conventional policies in the form of asset purchases, but we don’t see near term risks as a result of this.

The bigger long-term worry might be the build-up of public debt. Although the rise in public debt in emerging markets might win an ‘ugly contest’ with developed markets, a key question for emerging markets is whether investors, both domestic and foreign, have any confidence that these countries can grow out of their debt, and on this issue we are pessimistic. Low interest rates in developed markets might help push capital towards emerging markets, but that’s not a reason to be confident about the future of the asset class given the uncertainties that now afflict the global economy.