Our Emerging Markets (EM) Team attended the annual International Monetary Fund (IMF) and World Bank meetings last month in Washington, DC. Meetings included policymakers, IMF staff, political analysts and advisory firms, as well as speaking engagements on sustainable finance and ESG.
Key Takeaways from the Meetings
We’re in a period of simultaneous secular shifts. Energy and trade flows that have characterized at least the past two decades will not look the same going forward. The implications for markets will vary over the medium- to long-term, with both winners and losers emerging as a consequence of these shifts. In the immediate term, we expect financial conditions to remain challenging given the global repercussions of US monetary policy and the consequent need for US inflation data to turn more decisively lower before global conditions can start to stabilize, and eventually ease.
From a geopolitical perspective, it’s not clear how much the current trajectory can change. The energy arrangement that helped fuel European economic activity has unraveled. This has huge implications for relative prices and competitiveness, which have played out in currency markets. Away from Europe, strategic competition between the US and China will continue to strain the world’s most important trade relationship. The implications for both inflation and long-run growth will remain important, open questions. China’s determination to reengineer its growth model under the direction of President Xi Jinping adds further uncertainty to the outlook for the world’s second largest economy.
In parallel, US inflation dynamics have forced the Fed to pursue policies that increase rather than alleviate global financial strains. Tighter US financial conditions limit policy space globally. There’s very little room for a departure from orthodoxy in this environment, despite social and political pressures that push in the opposite direction. The risk of unexpected/systemic “cracks” will stay elevated in this environment, as previewed recently in the UK LDI experience.
For EM policymakers, there’s a lack of “good” options. Monetary policy had to tighten quickly. In countries that responded to inflation in a rapid and orthodox way, there’s more flexibility now to pause and await the Fed’s end point. But FX strains have surfaced in countries that do not have the resolve to pursue front-loaded hikes, or where existing policy inconsistencies have led to more fragile initial macro conditions. Countries that attempted to absorb the shock through the fiscal accounts, in an attempt to “look through” transitory pressures, now face the difficult task of unwinding accommodative fiscal policies in a still-challenging environment, with limited access to global markets.
Implementing fiscal retrenchment in the context of elevated food and energy prices will challenge lower-rated EM sovereigns. Debt service across single B issuers is probably manageable in 2023. Multilateral development banks (MDBs) and the IMF will help. Policy orthodoxy may eventually help unlock market access, but this outcome is probably path-dependent on the Fed. Sustaining a lack of market access indefinitely risks further instances of debt distress, and a worrying level of underinvestment in sustainable development objectives.
Sustainable finance was a focus in DC, and can potentially help stabilize EM capital flows—to a degree. Significant pockets of financing exist for countries that are willing to do the work on climate change mitigation and adaptation. Environmental best practice can also be a win-win (win) for policymakers, their constituents and investors alike—e.g., investment in adaptation can lower credit risks and improve social outcomes. Sustainable capital flows into EM economies have held up, despite the challenging backdrop, but still lag identified needs. Finding ways to scale these financing channels is a challenge that will require new sovereign debt instruments and better use of MDB balance sheets.
Our View of EM and Geopolitical Regime Shifts
China
Cyclical view: An end to zero-Covid policies, given the need to reboot the economy—as well as policy support to unwind some of the tightening we’ve seen in the property sector—will put China back on its pre-Covid growth trajectory, and help underpin a strong recovery next year.Secular view: Political consolidation following the 20th Party Congress will prioritize the CCP, and its role at the center of Chinese economic/political life. The fallout from property sector retrenchment will have a lasting impact on local government finances and the flow of credit in the economy. The political settlement on economic management, and the primacy of growth, which had been in place for decades, has been rewritten. China’s long-run growth will now depend upon the success of a more state-centric model, with limited technology transfer, given strategic competition with the US.Our view: The cyclical rebound may disappoint, and policy headwinds in the property sector, alongside demographics, and the changing character of political power, have all acted to downshift China’s growth potential. We’ve seen signals pointing to a gradual easing of zero-Covid policies, but we believe the reopening process will likely be quiet and piecemeal. This will support a gradual recovery of domestic investment, consumption and service sectors in China next year. But we adhere much more closely to the secular view for China. The growth model seeks to shift toward a more domestic-driven, services-based economy, with an emphasis on the quality of growth (real incomes, employment) over quantity (headline GDP growth rates). But the sharp drop in birth rates and an aging population point toward the limitations of this shift given China’s lack of a formal social safety net, and the role that property price appreciation had played in filling that gap. Given this context, we believe meaningful state support for consumers will be required for the transition to succeed.Russia-Ukraine
Cyclical view: A rational Russia would like to find a “win” and an exit; Russian elites would support this; Russian willingness to negotiate is genuine; Ukraine realizes, possibly at the behest of the West, that it needs to come to the negotiating table. Out of necessity, Europe and Russia will look for ways to rebuild some of the economic relationship that’s been shattered.Secular view: The current Russian administration’s survival requires a victory in Ukraine. Its principal vulnerability, in the near term, is from the political right. And so a weak prosecution of the war, or an attempt to frame “losing as winning,” puts regime continuity in jeopardy. Ukraine cannot concede what Russia requires. So escalation is the most likely path forward. Russia will lash out militarily within Ukraine, and simultaneously attempt to upend the social-political equilibrium that’s underpinned Western support for the Ukrainian war effort. Geopolitical realignment and the fragmentation of the European energy market are more or less permanent.Our view: We believe the economic fallout is structural, and mostly independent of battlefield developments. The current Russian administration does not have an off-ramp. Losing power is an existential threat to the regime’s inner circle, and, given perceived political vulnerabilities, the path to stay in power likely requires escalation of the conflict along multiple fronts. This does not necessarily imply high odds of worst-case scenarios. But even in a more bullish scenario, where the battlefield conflict “freezes,” more formally, along current lines, there’s not an economic reset in store for Europe or for Russia.Inflation
Cyclical view: US data is rolling over, and the Fed will likely see the need to pivot in fairly short order. There’s a risk that policy has already overshot and become too restrictive. US dollar strength will continue in the near-term, and EM central banks will feel pressure to continue the tightening cycle. That raises risks of an overshoot on monetary policy globally, creating an exceptionally difficult environment for global growth looking toward 1Q23. But prospects in 2023 can improve as the year progresses, given the likely scope for (possibly aggressive) rate cuts, with the potential for inflation downshifting materially.Secular view: US labor market and fiscal developments in response to the pandemic triggered a regime shift in the relationship between inflation expectations and wage-setting dynamics. The risk of a wage-price spiral will require the Fed to stay the course, until inflation data clearly turns lower, and inflation expectations look contained. The hope is that data may start to show clearer signs of a turn by 1Q23, giving the Fed an opportunity to fine-tune policy.Our view: The environment for EM will remain challenging in either scenario, underscoring the continued importance of orthodox monetary policy and a credible fiscal path. We expect the market to maintain its preference for “good policy” over “growth.” Credible central banks that hiked early and are seeing a rollover in core CPI data will have more flexibility to pause and wait for the Fed to finish, giving it greater capacity to weather the secular scenario described earlier. Inflation will continue to run hot in weaker country contexts, given US dollar strength, challenging funding conditions and still-high staple commodity prices, with fertilizer shortages a very real (and potentially more binding) constraint on 2023 food production. Different underlying drivers of inflation in the EU versus the US may allow the ECB to pause early. In the context of a still-weak economic outlook for the eurozone, however, risks to the euro-dollar cross continue to look left-hand-side skewed.
