## Emerging Markets’ Two-Way Traffic

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### Overview: contrasting policy directions
- Financially fragile emerging market economies are pursuing disciplined market-friendly reforms aimed at eliminating vulnerabilities.
- Some middle-income emerging market economies with healthier macroeconomic fundamentals are adopting, or seem likely to adopt, looser policies that could erode public sector balance sheets and push up country risk premiums.
- Examples of fragile countries pursuing reform: Argentina, Ecuador, Egypt, Ethiopia, Kenya, Nigeria, Pakistan, Sri Lanka, Türkiye.
- Examples of stronger economies moving toward looser policy: Brazil, Hungary, Indonesia, Mexico, Poland, Thailand.

### Bond market reaction and historical context
- Credit spreads of fragile-but-improving countries have narrowed disproportionately.
- In the first nine months of 2024:
  - Sub-investment-grade dollar-denominated sovereign debt in emerging markets returned more than 15 percent.
  - Investment in more creditworthy countries returned less than 5 percent.
- High-yield bonds can outperform investment-grade assets by more than 10 percentage points in the first nine months of a calendar year; over the past three decades this has happened only three times: in 1999, 2003, and 2009.
- Unlike those past episodes, the current environment lacks a recent major financial crisis for emerging markets or the world in general.
- Stock of sovereign debt in default was a mere half percent of global GDP last year, per a Bank of Canada and Bank of England sovereign default database; this is higher than a few years ago but much lower than the late 1980s when defaulted debt exceeded 2 percent of global GDP.

### Why some fragile countries are reforming now
- Two lessons learned by many developing economies:
  - Keep current account deficits within limits to reduce “flow vulnerability.”
  - Accumulate foreign exchange reserves to limit “stock vulnerability.”
- Self-insurance benefits and the need to limit flow and stock vulnerability are motivating reform, especially with US monetary tightening.

### Fiscal adjustments and spending trends (country examples and targets)
- Ambitious fiscal adjustments in fragile countries:
  - Argentina: aiming to turn a primary budget deficit of 3 percent of GDP in 2023 into a 1 percent surplus next year.
  - Egypt: targeting a primary surplus of 5 percent in the fiscal year ending June 2027.
  - Türkiye: plans to turn a primary deficit of 2.6 percent of GDP in 2023 into a surplus of 0.5 percent of GDP next year.
- Examples of fiscal loosening among countries with stronger balance sheets:
  - Mexico: 2024 budget deficit of some 6 percent of GDP, the largest since 1989.
  - Brazil: market concerns that a tilt toward fiscal loosening could conflict with financial stability despite a sovereign upgrade by Moody’s.
  - Indonesia: President Prabowo Subianto indicated willingness to let debt-to-GDP rise to 50 percent, up from 39 percent at present, to fund a new capital city, higher defense spending, and free school meals.

### Structural drivers: financial globalization vs real globalization
- Distinction:
  - Financial globalization created space for volatile capital flows.
  - Real globalization enabled a surge in trade.
- In the 1980s and 1990s: negative effects of financial globalization often coincided with positive effects from robust trade.
- Today:
  - Emerging markets appear better at managing volatile capital flows and responding earlier to risks.
  - Real globalization is weakening: global trade growth has been markedly weak compared with GDP growth in the past two years and much of the past decade.
  - Global trade hostility seems more likely to intensify, making exports a less reliable growth path.

### Risks, scenarios, and policy implications
- If fiscal easing in stronger-balance-sheet countries is:
  - Moderate, productivity-enhancing, and raises potential growth: looser policy may not alarm markets and two-way traffic could be benign.
  - Otherwise, especially if global trade deteriorates further: public sector balance sheets may weaken, and market participants could demand higher rates for credit.
- The future path of global trade could be decisive in determining whether emerging markets continue embracing market-friendly reform or move toward looser policies.

*David Lubin, Michael Klein Senior Research Fellow at Chatham House’s Global Economy and Finance Programme.*

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_Source: https://www.imf.org/-/media/files/publications/fandd/article/2024/12/pov-lubin.pdf_