Emerging Markets’ Two-Way Traffic

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Financially fragile emerging market and developing economies are pursuing disciplined, market-friendly reforms to eliminate vulnerabilities.
Some stronger, more historically stable emerging market economies are adopting looser fiscal or macroeconomic policies that could erode public-sector balance sheets and raise country risk premiums.
Label used in the piece: “two-way traffic” in emerging markets.

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.
In the first nine months of 2024, 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: 1999, 2003, and 2009.
Stock of sovereign debt in default was a mere half percent of global GDP last year, according to a database on sovereign default maintained by the Bank of Canada and the Bank of England.
By contrast, in the late 1980s the stock of defaulted debt was more than 2 percent of global GDP.

Fragile economies undertaking ambitious fiscal adjustments:
- 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.
Countries leaning toward looser policies despite stronger balance sheets:
- Mexico: President Claudia Sheinbaum inherited a 2024 budget deficit of some 6 percent of GDP, the largest since 1989.
- Brazil: market concerns that fiscal loosening under President Luiz Inácio Lula da Silva could be incompatible with financial stability despite a Moody’s sovereign upgrade.
- Indonesia: President Prabowo Subianto has raised the prospect of letting the debt-to-GDP ratio rise to 50 percent, up from 39 percent at present.

Two contrasting forms of globalization:
- Financial globalization: created volatile capital flows in recent decades but many developing economies now manage flow and stock vulnerabilities better.
- Policy lessons emphasized: keep current account deficits within limits (limit flow vulnerability) and accumulate foreign exchange reserves (limit stock vulnerability).
- Real globalization: trade growth has been weak versus GDP growth over the past two years and much of the past decade; rising global trade hostility could reduce export reliability as a growth path.
The weakening external trade environment may encourage fiscally healthier countries to use accumulated reputational capital to support domestic demand, especially to finance climate transition and national defense needs.

If fiscal easing in healthier countries is:
- Moderate, productivity-boosting, and adds to potential growth → may not alarm markets and two-way traffic could be benign.
- Large or poorly targeted, especially amid a steeper or protracted collapse in global trade → public-sector balance sheets could deteriorate further and markets would likely demand higher rates to supply credit.
The future trajectory of global trade is a key determinant of whether emerging markets broadly embrace market-friendly reform or shift toward looser policies.

The current pattern differs from past episodes where high-yield outperformance followed major crises; here, outsized returns for fragile-but-improving issuers have occurred without a recent major financial crisis.
The observed policy divergence reflects both improved crisis management (self-insurance through reserves and constrained current account deficits) and pressures from weakening real globalization that incentivize fiscal support for domestic priorities.

Source: Emerging Markets’ Two-Way Traffic, F&D Magazine, DAVID LUBIN, December 2024.

Emerging Markets' Two-Way Traffic
- Emerging Markets' Two-Way Traffic (Markdown version)
- Emerging Markets' Two-Way Traffic (PDF)