Warren Buffett famously said that when the tide goes out, we find out who has been swimming naked. By this he meant that when liquidity conditions are no longer favorable, we find out which borrowers did not make good use of the money that earlier they were able to borrow so freely.
Buffet’s warning is particularly apposite concerning the emerging market economic outlook for 2022. At the very time when the emerging economies are saddled with record amounts of debt and have poor public finances, their borrowing conditions are likely to become less favorable. The global “everything” asset price bubble might burst, and China’s property and credit-led growth model could run out of steam. With China being the world’s largest consumer of international commodities, any meaningful slowing in its economy could weigh heavily on the world commodity prices on which many emerging market economies are so dependent.
Amid the COVID-19 pandemic, emerging market public finances do not appear to be in a good position to withstand rising international interest rates, declining commodity prices or a renewed slowdown in world economic growth. According to the International Monetary Fund (IMF), over the past 18 months, emerging market economies’ budget deficits widened to 6.5 percent of GDP. Meanwhile, their public debt-to-GDP ratio increased by some 10 percentage points, to a record 64 percent. Worse yet, some very large emerging market economies such as Brazil and India now have public debt-to-GDP levels in excess of 90 percent.
Over the past two years, despite the pandemic-induced deterioration in their public finances, the emerging market economies were kept afloat by the unprecedented pace of bond buying by the world’s major central banks aimed at keeping interest rates at ultra-low levels. This buying saw the combined balance sheet of the Federal Reserve and the European Central Bank increase in the space of 18 months by a staggering $10 trillion.
This year a major challenge for the emerging market economies will be how to cope with a decidedly less benign international liquidity environment than last year. With U.S. inflation now at a 40-year high and unemployment back down to its pre-pandemic lows, the Fed has indicated that it will end its bond buying program by March with a view to paving the way for an early start to an interest rate hiking cycle. With European unemployment at pre-pandemic levels and with European inflation now at its highest level since the 1999 launching of the euro, the European Central Bank cannot be far behind the Fed in turning off its monetary policy spigot.
The major risk to the emerging markets from a Fed tightening cycle is that it could induce a substantial amount of capital repatriation away from the emerging markets as has occurred on many previous occasions of rising U.S. interest rates. That would be particularly the case should the Fed tightening cycle be the trigger that bursts today’s global “everything” asset price and credit market bubble. In a world where investors are reducing their risk exposure, the emerging markets would likely be especially hard hit.
Another major risk for the emerging market economies this year would be a further slowdown in Chinese economic growth. That risk now appears to be likely given the acute problems in China’s property sector, which accounts for almost 30 percent its economy. Those problems mean that we would no longer be able to count on China as the world’s major economic growth engine.
U.S. economic policymakers ignore the emerging market economies’ darkening economic prospects at their peril. Not only do those economies now account for around half of the world economy; they also pose considerable risks to the U.S. and global financial systems, which hold record amounts of emerging market debt on their books. As such, emerging market trouble could spill over to the U.S. and world economies.
Desmond Lachman is a senior fellow at the American Enterprise Institute. He was formerly a deputy director in the International Monetary Fund’s Policy Development and Review Department and the chief emerging market economic strategist at Salomon Smith Barney.