Pre-pandemic, vulnerabilities in some EM economies had mounted amid slowing economic growth. As Fig. 1 shows, countries in the bottom right (Brazil, Egypt, Ukraine, South Africa) had limited fiscal space going into the health crisis as they already had high public-debt-to-GDP ratios.
Since the onset of the current crisis we have seen a surge in debt ratios as recession hit. For the moment there is a tolerance in markets towards higher fiscal deficits and public debt (that we closely monitor), but actions to restore fiscal sustainability will be required once the recovery gets underway.
Tracking debt sustainability
Our proprietary ‘Debt Sustainability Score’ looks for a potential negative drift in government indebtedness before it becomes irreversible, using a range of tested inputs. Our ‘Shorter-Term Debt Score’ model detects shorter-term momentum shifts based on quarterly inputs. In fig. 2 below we combine the latest readings of both models.
This chart shows us two things. First it identifies countries with good debt dynamics in the green quadrant: Taiwan particularly and Eastern Europe, especially Bulgaria. Conversely the red quadrant shows us less favourable markets: foremost Brazil (of which more from our EM debt team below), South Africa and Egypt.
Second it flags markets which are seeing short-term shifts that might point to improvements or deteriorations in their longer-term debt sustainability score. Improving on the margin are Chile and Turkey.
Meanwhile a range of markets are seeing short-term deteriorations with possible long-term consequences: foremost the Philippines, but also Malaysia, China and Romania.
A view from our EM Debt Team on Brazil
Brazil has been one of the worst affected countries during the Covid-19 crisis, with a large number of virus cases, significant restrictions and economic disruption.
The fiscal and monetary policy response has been timely and very powerful – involving large social transfers and a significant widening in fiscal balances as well as monetary policy easing and liquidity provision.
The large fiscal impulse in Brazil presented below, during a time of mounting debt to GDP, has unsettled market participants. Very low interest rates have also weighed on the currency, further exacerbated by a difficult environment for EM FX globally.
More recently however, it is becoming clear that the Brazilian real (BRL) has become an increasingly domestic/idiosyncratic story, heavily centered around the outlook for fiscal policy. While we expect the external environment to improve, through a gradual although somewhat uneven global recovery and the prospect of a vaccine in 2021, we believe that BRL will continue to be dominated by domestic fiscal news flow and policy coordination.
The way forward...
In particular, we believe that Brazil needs to set out clear policies for maintaining the fiscal spending ceiling by allowing a gradual expiry of temporary fiscal measures, identifying spending cuts and pushing ahead with a more ambitious reform agenda. Should such a scenario materialize, likely over the next few months, we believe the risk premium specific to Brazil can be priced out from the currency, allowing the BRL to strengthen.
Restoring fiscal credibility in Brazil together with an improving growth/virus picture, strong commodities backdrop and a positive external balance picture should translate into a reversal of this year's significant underperformance. Of course, if there is evidence that the spending cap is not being respected it could mean further currency weakness, as the debt sustainability issue becomes the dominant driver of Brazilian assets.
By Sabrina Khanniche, Economist in the Fixed Income team, and Mary-Therese Barton, Head of Emerging Market Debt at Pictet Asset Management.
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Sabrina Khanniche joined Pictet Asset Management in 2011 as Economist in the Fixed Income team. Before joining Pictet, she was with Groupama Asset Management during four years as a Financial Engineer in charge of the anlysis and modelling of hedge fund risks. In this regard, she published and presented her work in international academic conferences. Sabrina holds a Master a PhD in Economics from the University of Paris West Nanterre La Défense.
Mary-Therese Barton joined Pictet Asset Management in 2004 and is the Head of Emerging Debt. Before taking up her current position in 2018, she was a Senior Investment Manager in the team. Mary-Therese joined as an Emerging Debt Analyst. Prio to joining Pictet she worked at Dun & Bradstreet, where she was an economist responsible for analysing European countries. Mary-Therese graduated with a BA (Hons) in Philosophy, Politics and Economics from Balliol College, Oxford.