Once one of the poorest and least developed regions of the world, Asian economies have exploded on the international stage in the 21st century to become some of the world’s most dynamic economies. Together with other developing economies, they are viewed by professional investors as an asset class of their own: Emerging Markets (EMs). 

While the Covid-19 pandemic has hurt the global economy; it is hitting EMs especially hard. At the DBS Asian Insights Conference held over July 23 and 24, senior minister Tharman Shamugaratnam warned that the economic pressure of Covid-19 can lead to a very real risk of EM economic gains unravelling. Former International Monetary Fund (IMF) chief economist Raghuram Rajan sees EMs like Mexico, India and Peru losing economic muscle with each passing day. He predicts an incomplete recovery for EMs and fiscal weakness going forward. 

Indeed, the pandemic is both a public issue and an economic struggle for EMs. “Generally, EM countries have fallen behind Developed Markets (DMs) in terms of containing the outbreaks, in terms of flattening their infection curves,” says DBS forex and rates strategist Duncan Tan, with case numbers still climbing in India, Indonesia and the Philippines. 

With generally weaker national healthcare systems, EMs are at greater risk of additional waves of Covid-19 infections, warns Tan. The need for greater government fiscal support due to weaker short-term economic growth could weaken longer-term EM growth potential and increase debt-to-GDP ratio, he says, leading to lower credit ratings and higher borrowing costs. 

Institute of International Finance (IIF) economists Emre Tiftik and Khadija Mahmood were quoted in a Bloomberg report saying about US$3.7 trillion ($5.07 trillion) of emerging-market debt will come due through end-2020, with foreign currency-denominated debt accounting for nearly 17% of the total. Furthermore, IIF predicts global debt to reach US$258 trillion in 1Q2020, or a record 331% of the world’s GDP. EM debt ratios are seen to grow by a record 230% of GDP in 2020. 

Living on borrowed time? 
But James Crabtree, associate professor from the Lee Kuan Yew School of Public Policy, sees EMs suffering from longer-term structural challenges stemming from the retreat of globalisation. At a virtual webinar organised by the Asia Society Switzerland titled The End of Emerging Markets?, he argues that the global economy’s increasing retreat from free trade would spell the end of a perhaps unusual era of rapid catch-up growth for EMs. 

“It was really the golden years of globalisation before the financial crisis that gave EMs this huge boost as they integrated into the global system,” Crabtree cautions, noting that catch-up growth had already begun to peter out even before Covid-19. This could have a significant human cost, he warns, noting that anti-poverty gains made during the past few decades could well be reversed for some of these countries. Greater political instability could thus emerge, with local populations likely to turn to nationalism in reaction to this loss of economic fortunes. 

But the impact of the present crisis has been uneven, even among EMs. East Asia, notes Crabtree, has arguably been the most successful region in managing the crisis and benefits from the strength of the Chinese economy — perhaps the only one in the world that will avoid entering recession this year. South Asian states, meanwhile, will be especially affected due to a lack of state capacity, making it more difficult for them to replicate the Chinese economic miracle.

“For Latin America however, the recovery will be slower as countries are struggling more with the Covid-19 pandemic. Latin America is also hampered by weaker public finances, greater political uncertainty and lower structural growth rates resulting in a longer time to recover for Latin America compared to Asia,” agree Jamie Grant and Anthony O’Brien of First State Investments, although they are sceptical that the slowdown of globalisation will be a permanent one. 

Year to date, the benchmark MSCI Emerging Markets Index is up 1.83%; the S&P 500, a broad measure of the US market, is up 7.93% in the same period. The tech-heavy Nasdaq, meanwhile, has gained 28.66%. 

Mary Nicola, multi asset portfolio manager at PineBridge Investments, echoes these concerns. Key drivers of EM growth such as strong Chinese growth, technology transfer, cheap labour costs and the commodity supercycle were already losing steam. Covid-19 merely helped hit the brakes harder. Weak implementation of structural reforms to improve labour market competitiveness and introduce investment-friendly land laws will dampen EM competitiveness, she says, eroding growth differentials between EMs and DMs over the next five years. 

That being said, Crabtree does not think that catch-up growth is now impossible for EMs. A combination of competent leadership, economic reforms, strong state capacity and the ability to seize opportunities in growth industries will still see countries like Vietnam continue to enjoy good economic prospects with growth rates that outpace DMs. However, without the tailwind of globalisation, catching up with the Global North has become that much harder.

Andy Budden, equity investment director at Capital Group, is less pessimistic about the state of globalisation and the fate of EMs. “We don’t see globalisation retreating, we see it changing shape. We think it would be premature to assume that EM growth sees a sustained decline. The composition of the drivers of future growth could well be different to what we have seen in the past,” he tells The Edge Singapore. 

Dancing with debt
In light of this sombre prognosis for EMs, several financial institutions have turned cautious on EMs. United Overseas Bank (UOB), for instance, recently issued a White Paper on the post-Covid-19 economy predicting a growing gap between the financial fortunes of EMs and DMs. Without the financial firepower of the wealthier DMs, weaker EM economies will likely need more debt relief or restructuring in years to come, thereby widening the disparity.

G7 nations have the means to undertake monetary and fiscal stimulus. On the other hand, emerging economies do not often have this ability to stimulate post-Covid-19 recovery. “We foresee a rising divide between DM and EM economies, with the latter increasingly at risk of being left behind,” write Choo Chian, UOB’s multi-asset strategy director and Chong Jiun Yeh, its chief investment officer. Vulnerabilities in EM sovereign high-yields (HY) have been exposed by the crisis, with many of these stretched too thin in the context of easy liquidity.

Kelvin Tay, regional chief investment officer at UBS Wealth Management, calls on EMs to tap cheap credit to fund much-needed infrastructure investment and economic restructuring. But Choo and Chong of UOB warn that economic pressures could make this a tall order for weaker EMs despite lower borrowing costs. They see single “B”-rated sovereigns from EMs such as Ghana, Nigeria and Pakistan cutting back spending in order to meet interest payments and foot the bill for higher healthcare costs and economic stimulus, leaving less funds for investment.

Nicola of PineBridge also fears that these fiscal challenges could stymie much-needed structural reforms in EMs. These measures often necessitate short-term pain before long-term gain, and thereby a tough challenge for governments without enough political will. Ironically, not implementing such policies could impede EM recovery in the long run, especially since such reforms were unsuccessful even in the bull market pre-Covid-19, she tells The Edge Singapore. 

Such headwinds could prove fatal for EM prospects as growing geopolitical and supply chain risks might inspire a “manufacturing renaissance” in DMs. “Reshoring activity back to DM economies would accelerate as firms no longer consider the cost savings of offshoring to be worth the risk,” according to UOB. 

Consequently, the low-cost manufacturing model of growth that has driven EM economies could come under threat, with automation already prompting some firms to reshore manufacturing to DMs. Tay of UBS estimates Southeast Asia will need 15 years to restructure its economy before it gets eclipsed by automated manufacturing, with greater infrastructure and education investment needed to move up the value chain.The Asian Development Bank (ADB) estimates that Asean needs US$21 billion to maintain its current growth trajectory, which may be harder to obtain with lower growth and more difficult credit access.

UOB also expects very low growth from EM HY sovereigns in the coming years, further slowing structural reforms and even triggering political instability. On the other hand, secular investment themes like automation and digitisation could be promising as reshoring occurs in DMs. Nicola also finds EM equities less favourable going forward as growth differentials between EMs and DMs narrow, since these do best under strong growth conditions.

Investors’ confidence has already been shaken. “There has been a preference among many clients to tilt portfolios towards DMs and large cap technology exposure in the short term, given the uncertainty created by Covid-19 … rather than the long-term growth opportunities that many EM businesses offer,” says Ross Teverson, head of strategy, Emerging Markets at Jupiter Asset Management. 

The silver lining
Nevertheless, Tay sees some silver linings in EMs. The debasement of the US dollar due to quantitative easing has been a significant boost to EM prospects, for example. Duncan Tan of DBS also notes that flush US dollar liquidity is typically correlated with strong EM asset performance, since capital is likely to flow into EMs in search of yield. Ample liquidity could also embolden investors to place their bets on EM assets despite the risks involved. 

Tay says it is also important to consider the composition of EM assets. He points out that 80% of EM equities comprise Asia ex-Japan assets. These economies have dealt best with the Covid-19 pandemic compared to many DMs like the US and UK, with China in particular emerging quickly from lockdown to gain a headstart in growth. EMs other than China could benefit from the re-routing of supply chains away from China as businesses look to reduce supply chain reliance on China and avoid paying more for its increasingly expensive labour. 

“From a macro standpoint, China currently enjoys the “best of all worlds”. Its post-pandemic recovery has been exemplary thus far,” says OCBC’s executive director of investment strategy Vasu Menon. He recommends investors make a defensive play on EM high-yield assets leaning towards Asia/China and China property sector bonds, with the latter benefitting from a rapid recovery in developer pre-sales from their Covid-19 troughs.

Budden of Capital Group believes higher productivity growth in EMs — which far exceeds that of DMs in the long-run — will also help to cushion EM performance as well. Yet, with productivity growth declining since the 2008–2009 Global Financial Crisis, there are fears that the shock of Covid-19 will speed up this decline. 

But no reward ever comes without risk. Claudia Calich, fixed income fund manager at M&G Investments, sees higher yields in EMs comparing favourably with lower yields in DMs, with EM opportunities that can make up for the added default risks still available on a selective basis. Following a solid 2Q2020 rally by EM bonds, she sees their long-term valuation remaining attractive compared to DM bonds despite offering less potential upside at the end of the quarter. Primary issues in EM bond markets over the last three months were oversubscribed in the last three months as markets began a search for yield. 

“I think in general, people are cautiously optimistic ... in the sense that they recognise that there has been a floor under asset markets with the amount of fiscal and monetary policy that has been deployed,” says Nicola. Still, she believes that EMs are currently in a state of stabilising rather than stimulating stronger growth. But whether EMs can eventually return to the days of rip-roaring expansion is perhaps too soon to say.