This note summarizes my presentation for the AEI Event, “The
Debt Challenge of Emerging Market Economies”, October 28, 2020.[1]

How likely are emerging market (EM) economies to default? Even before the coronavirus pandemic, many of them were taking on debt and building up significant vulnerabilities. In consequence, as shown in Figure 1 below, the outbreak of the pandemic threatened to trigger a wave of defaults as EM currencies plunged, credit spreads widened, and equities collapsed. However, this turmoil subsided soon thereafter, and the major emerging market economies generally regained access to international capital markets, thanks in large part to the sharp declines in interest rates orchestrated by the Federal Reserve (Figure 2) and other central banks around the world. Such low rates reduce the burden of external debt service while making higher-yielding EM assets more attractive to global investors.

Observers have warned that once the pandemic gets under control, the economy recovers, and interest rates normalize, EM borrowers will again run into trouble. While certainly possible, this is by no means a foregone conclusion. Let me review some different scenarios for interest rates and EM outcomes.

The Good

In the good scenario, which is
generally consistent with the forecasts of institutions such as the IMF or
World Bank, the pandemic comes under control by next year, and the US and
global economies continue to recover. But inflation rises only gradually,
consistent with its subdued behavior of recent years. In the past, economic
recovery would have prompted concerns about a tightening of monetary policy by
the Fed that triggered disruptive spillovers to emerging markets. But this most
likely wouldn’t happen in this scenario, for two reasons.

First, consistent with the Fed’s
newly announced strategy of seeking some overshoot in the inflation rate to
make up for past shortfalls, interest rates would likely rise only very slowly.
In the illustrative scenario shown in Figure 3, the Fed funds rate stays near
zero, consistent with the FOMC’s own Survey of Economic Projections. The
10-year yield follows the path implied by the current Treasury yield curve; although
I’ve added an additional 50 basis points by the end, as low-for-long scenarios
drop out of market expectations, it remains quite low.

A second reason for optimism is that
as long as increases in interest rates are driven by faster economic growth
rather than higher inflation, their spillovers to emerging markets will likely
prove benign. This is because higher growth in the United States leads to
higher exports abroad and bolsters debt service capacity, offsetting the effect
of additional interest payments. Figure 4 displays the results of research by
myself and my Fed ex-colleagues Jasper Hoek and Emre Yoldas, in which we
contrast the effects on EM economies of US interest rate hikes driven by
improved growth prospects with those driven by higher inflation.[2] A
rise in US interest rates driven by inflation leads in EM economies to sharp
currency depreciations, widenings of credit spreads, higher bond yields, and
declines in equity prices; however, higher interest rates driven by faster
growth exert negligible effects.

Of course, this doesn’t mean there
would be no EM defaults in this scenario. Argentina and Ecuador have already
defaulted or restructured their debt, and I’d expect this year’s global
recession to push a few of the more vulnerable EMEs into difficulties. After
all, in Clint Eastwood movies, even the good guys are not all good.

The Bad

Lest the reader think I’m hopelessly optimistic, I have not one but two bad scenarios. The first is suggested by the spillover estimates displayed earlier: As in the good scenario, the pandemic eases by next year and economic growth recovers as generally projected. However, inflation surprises on the upside, perhaps reflecting supply-side shocks from the pandemic, and this boosts inflation expectations. In this scenario (Figure 5), the Fed funds rate remains depressed by the Fed’s desire to allow some overshooting. But higher inflation expectations, plus the return of a positive term premium, pushes 10-year Treasury yields up to 4 percent. In the way of self-fulfilling prophecy, this surge in interest rates exacerbates EM debt burdens and leads, as illustrated in Figure 6, to sharp disruptions in emerging markets that trigger widespread defaults.

The second bad scenario is associated
not with a spike in global interest rates, but with their implosion. A sharp
global resurgence of the pandemic throws global financial markets back into
turmoil. Interest rates fall to zero amid flight to safety flows (Figure 7),
but this offers scant help to emerging markets, which again suffer widespread
disruptions and defaults.

The Ugly

In the final scenario, there is neither a steady economic recovery nor a catastrophic resurgence in the pandemic. Instead, unexpectedly slow progress in containing the disease leads to prolonged global recession. US interest rates hold at current low levels (Figure 8), but continued economic weakness puts the more vulnerable EMEs under pressure.

Figure 9 plots the increase in the
EMEs’ sovereign debt-to-GDP ratios between 2019 and 2021, as projected by the
IMF, against the change since January in these countries’ dollar interest rates.
Most countries show higher government debt but lower interest rates, so the
change in debt sustainability is unclear. But both debt and interest rates have
risen for three countries — Brazil, Turkey, and South Africa — suggesting that
they may be unusually vulnerable in this ugly scenario.

 Conclusion

Your final figure (10) assigns
subjective (but plausible) probabilities to the above scenarios: 50 percent, 10
percent, 20 percent, and 20 percent. They suggest that a wave of EM defaults is
not preordained, but even so, there is plenty of cause to worry about prospects
for emerging markets.

[1] https://www.aei.org/events/the-debt-challenge-of-emerging-market-economies/ I would like to thank John Kearns for excellent research assistance, and Jasper Hoek, Ben Smith, and Emre Yoldas for helpful comments and updated data.

[2] Hoek, Jasper, Steve Kamin, and Emre Yoldas (2020). When is Bad News Good News? U.S. Monetary Policy, Macroeconomic News, and Financial Conditions in Emerging Markets. International Finance Discussion Papers 1269. https://doi.org/10.17016/IFDP.2020.1269

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