Emerging markets risk financial difficulties as rates start to rise, IMF warns

Soaring inflation and sharply rising borrowing costs in the United States and Europe threaten to push debt-ridden emerging and developing economies into further financial woes, a senior IMF official has warned.

Nearly a quarter of emerging market countries that have issued “hard currency” debt have bonds now trading in troubled territory, with spreads more than 1,000 basis points above good ones. from the US Treasury, according to the multilateral lender.

Borrowers around the world took advantage of aggressive monetary easing by the Federal Reserve and the European Central Bank and issued debt securities denominated in dollars and euros at extremely low rates. But borrowing has become more expensive as central banks seek to combat price pressures with tighter monetary policy.

Tobias Adrian, who heads the fund’s money and capital markets department, suggested that distress levels were likely to rise further if central banks in advanced economies intervened too abruptly or aggressively to reverse stimulus measures. monetary policy injected at the start of the pandemic.

“There are certainly many countries that are already in distress or potentially will be in the near future,” he said in an interview with the Financial Times. The IMF on Tuesday lowered its forecast for growth in emerging markets and developing economies to 3.8% this year, down one percentage point from its January estimate.

“At some point, some large emerging markets may also get into trouble and the situation may change. . . This is not in our baseline scenario at the moment, but it depends on the severity of the evolution of financial sector shocks,” added Adrian, noting that the amount of debt at risk is not “of systemic nature at this stage”.

Particularly vulnerable countries included commodity and food importers such as Egypt and Bhutan, he said. Tunisia and Sri Lanka also struggled, with the latter defaulting on debt this month.

In its biannual Global Financial Stability Report, released on Tuesday, the IMF said central banks in advanced economies were walking a tight “tightrope” as they tried to rein in the highest inflation in about four decades amid rising geopolitical tensions, weakening global growth and seesaw financial markets.

Traders now expect the fed funds rate to drop to 2.5% by the end of the year, from its current level of between 0.25 and 0.50%. The ECB is also expected to raise rates for the first time in over a decade later this year.

The Fed’s attempts to tackle price pressures could hit emerging markets laden with foreign-currency debt, the IMF warned on Tuesday.

The fund said: “A disorderly tightening of global financial conditions would be particularly difficult for countries with high financial vulnerabilities, unresolved pandemic-related challenges and large external financing needs.”

Tobias Adrian, Head of the IMF's Monetary and Capital Markets Department
Tobias Adrian, Head of the IMF’s Monetary and Capital Markets Department: “There are certainly many countries that are already in trouble or potentially will be in the near future” © Alex Kraus/Bloomberg

Debt levels in emerging market economies have risen sharply in recent years, with total debt outstanding rising to nearly $100 billion at the end of 2021 from less than $65 billion about five years ago, according to the Institute of International Finance.

Global financial conditions have already tightened in recent months as inflationary pressures worsened following Russia’s invasion of Ukraine.

Adrian said the shift to less accommodative monetary policy had gone smoothly, but warned the Fed and other central banks would need to proceed with caution and communicate clearly to ensure this remains the case.

“Right now, monetary policy in the vast majority of countries is being tightened, which is exacerbating downward moves in sovereign debt.”

In addition to raising rates, the Fed will shrink its balance sheet by $9 billion by halting reinvestments of proceeds from maturing Treasury bills and agency mortgage-backed securities it holds. If his actions disrupt markets and lead to a destabilizing selloff, Adrian said he expects the U.S. central bank to moderate the pace at which it has allowed his securities holdings to shrink.

The change in central bank policy – ​​coupled with the fallout from the war in Ukraine and the sanctions imposed by the United States and its allies on Russia – has also eroded market liquidity, leading to greater price fluctuations. The IMF warned on Tuesday that there were “some signs” that rising volatility could weigh on banks’ ability to lend and trade.

The fund pointed to the chaos in commodity markets that led to an eight-day suspension of nickel trading on the London Metal Exchange this year. JPMorgan Chase disclosed a loss of $120 million related to the transaction last week.

Huge swings in commodity prices triggered large margin calls on short positions. These margin calls were, according to the fund, “testing the resilience of corners of the global financial markets that were little known to the general public only a few weeks ago”.

Sarah J. Greer