Emerging market debt hits breaking point

For most of 2022, the U.S. flip-flop and rush to raise rates has certainly put pressure on stocks, bonds and, to some extent, housing in the United States.

But more importantly, the actions of Fed leaders are accelerating the risk that something, or some things, will break in foreign markets. The Fed can be seen as the global central bank that pretty much dictates how other central banks will shape monetary policy, leaving financial regulators elsewhere with little choice if they want to prop up their respective currencies.

It is this main focal point that is likely to be the source of the noise of something ‘snapping’ overseas in the form of a major default by a large emerging market, a liquidity freeze in the sovereign bond market or non-linear price action in the foreign exchange (forex) market, where a major currency decouples in panic selling. According to a recent World Bank statement in September, rising global borrowing costs are increasing the risk of financial stress among many emerging markets and developing economies over the past decade and accumulating debt at the fastest rate since. more than half a century.

Even as massive swings in UK bonds, amid policy missteps by Prime Minister Liz Truss, forced the Bank of England to step in and let pension funds unwind risky bets, its actions did little to help. only to temporarily support the pound’s free fall. Last week, the British pound started to roll, and it could well revisit or even eliminate the September 28th low.

What will prevent that from happening with the dollar index, which tracks the dollar against a basket of currencies of advanced economies, rising beyond its 20% rise during the last year ? The movement against emerging market currencies has been considerably more dramatic in terms of exchange rates and inflation. Much of the emerging market debt issued must be repaid in dollars, and all oil transactions around the world are done in dollars, which is considered the world’s reserve currency.

If or when something breaks, it could be related to a debt service crisis. A recent Allianz report concluded that “the current debt-to-GDP ratios in France (113%), Italy (151%) and Spain (118%) imply a Herculean fiscal consolidation effort to avoid a hanging. interest rates” as debt servicing costs soar higher. Japan’s public debt represented 231% of the country’s nominal gross domestic product (GDP) in June 2022, compared to a ratio of 229% in the previous quarter. Last Tuesday, the yen hit a new 24-year low against the dollar, down about 27% in 2022 alone.

As troublesome as the weaker currency issues in the UK, EU and Japan are, it seems that the biggest short-term risk from that sound of glass breaking in the distance is emerging market debt. A systemic sell-off could be underway, given the rising dollar is intensifying debt levels in emerging markets. Without a policy shift from the Fed to virtually freeze the $95 billion-a-month quantitative tightening program, this may well be the dam-breaking force.

Emerging market borrowing, led by China which inflated the global debt mountain to a record $303 trillion in 2021, shows the global debt-to-GDP ratio has improved as developed economies rebounded, the Institute of International Finance said. The $10 trillion increase in global debt was down from the $33 trillion increase in 2020 when COVID-19-related spending soared. But more than 80% of last year’s new debt burden came from emerging markets, where total debt is approaching $100 trillion, the institute reported in its annual Global Debt Watch report. Learn more here.

The most widely traded emerging markets bond exchange-traded fund (ETF) is the iShares JP Morgan USD Emerging Markets Bond ETF (EMB), with around $13.8 billion in assets under management, trading around seven million shares per day. It mirrors the health of the undeveloped world debt market about as much as possible, in terms of getting a real-time measure for the overall market for that particular asset class.

Because it is a managed fund, it does not represent the severity of risk within the broader emerging market debt market, as China only accounts for 1.88% of assets. Other highly indebted countries also have smaller positions, according to the list of holdings below.

Mexico 5.69%
Indonesia 5.50%
Qatar 4.76%
Turkey 4.52%
Saudi Arabia 4.39%
United Arab Emirates 4.15%
Philippines 3.92%
Brazil 3.77%
Oman 3.70%
Peru 3.38%
Dominican Republic 3.25%
South Africa 3.21%
Colombia 3.14%
Chile 3.13%
Panama 3.12%
Bahrain 3.05%
Egypt 2.69%
Malaysia 2.48%
Uruguay 2.35%
Kazakhstan 2.04%
Nigeria 1.95%
China 1.88%
Hungary 1.83%
British Virgin Islands) 1.72%
Romania 1.50%
Argentina 1.27%
Ecuador 1.27%
Angola 1.26%
Cayman Islands 1.24%
Jamaica 0.96%
Kenya 0.89%
Ghana 0.85%
Kuwait 0.83%
Azerbaijan 0.77%
Pakistan 0.75%
Jordan 0.71%
India 0.67%
Poland 0.62%
Netherlands 0.60%
Costa Rica 0.59%
Sri Lanka 0.57%
Ukraine 0.56%
hong kong 0.56%
Paraguay 0.54%
Senegal 0.30%
Morocco 0.30%
Iraq 0.28%
Croatia 0.27%
Zambia 0.26%
Guatemala 0.24%
Ivory Coast 0.20%
El Salvador 0.20%
Vietnam 0.19%
Trinidad and Tobago 0.17%
Serbia 0.15%
Bolivia 0.14%
United States 0.14%
Gabon 0.14%
Tunisia 0.11%
Lebanon 0.10%
Ethiopia 0.10%
Australia 0.08%
Venezuela 0.04%

More importantly, however, this fund has Mexico as its top holding. With Mexico the largest trading partner of the United States, the fund is crushed, falling 30% since the start of the year (YTD), as the dollar and interest rates rise to fight inflation . The EMB chart is flashing red and should be viewed by the Federal Reserve as a market where it’s not a matter of ‘if’ but ‘when’ it breaks as the biggest holders of emerging market debt are the banks of the countries that issue the debt, as well as a significant amount held by European banks.