Rising US Dollar Will Test EM Vulnerabilities Across Sectors

May 17, 2018/Fitch ratings

The benefits of a weak dollar and rising commodity prices, which supported strong emerging-market (EM) growth in 2017, are now beginning to fade, says Fitch Ratings in a report published today. This will leave EM issuers facing more challenging economic and financial conditions as interest rates rise and central bank monetary policy becomes less accommodative.

EM debt securities outstanding have ballooned to USD19.3 trillion, up from USD5 trillion a decade ago. China accounts for more than half (USD11 trillion), up sharply from only USD1.5 trillion in 2007.
“If easy financial conditions tighten more sharply than expected, EM debt would come under pressure,” said Monica Insoll, Head of Fitch’s Credit Market Research Team.

Internationally issued securities now account for a smaller share of total EM debt, at 12%, down from 16% 10 years ago. Many large EM countries have developed local-currency bond markets to avoid “original sin” – borrowing in hard foreign currency and being exposed to rising debt-service costs if foreign exchange rates move against them. Nevertheless, some EM borrowers remain vulnerable to rising US interest rates, a stronger dollar and the slowdown of capital inflows.

“Foreign investors have increasingly bought domestic-currency bonds, seeking both credit and currency gains. If investor appetite for EM risk reverses, issuers may face refinancing challenges even in their home markets, while capital outflows could put pressure on exchange rates or foreign exchange reserves,” added Insoll.

The US dollar had remained surprisingly weak after the Fed began its rate rise cycle in December 2015 but it has recently started to rise as Treasury yields hit 3% at the end of April. Some countries have therefore felt increasing pressure on their currencies, notably Argentina, Turkey and Brazil.

The fundamental EM credit quality backdrop is mixed. Defaults are down from the highs of 2016 and rating outlooks are evenly balanced between positive and negative across all major sectors. But there were significant net EM sovereign downgrades over 2014-2017, reflecting the drop in commodity prices as well as political and other idiosyncratic factors.

The report, which covers the top 20 EM countries by debt volumes and overall interest to investors, assesses vulnerabilities to monetary policy tightening across the sovereign, bank and corporate sectors. The most vulnerable countries are Ukraine, Turkey and Argentina, all non-investment grade, but our analysis also highlights pockets of risk in higher-rated countries. Reliance on external debt securities is also high in UAE, Qatar, Peru and Kazakhstan.

It also assesses China as a medium-risk country, whose main challenges are high debt across the broader economy and the liquidity profiles of mid-tier banks. Areas of risk elsewhere among EMs include idiosyncratic political risk, with a heavy election calendar this year.

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