Outlook 2023: Emerging markets investors keep eye on China, sovereign risk, FX

Chicago, Dec. 30 – In spite of surprises for the economy, including a war that threw Russia out of the global financial system, emerging market debt supply for 2022 was $527.36 billion near year’s end, according to data compiled by Prospect News.

The total, from 1,225 tranches of debt, includes all currencies.

Overall issuance for 2022 was predicted to reach $679 billion.

Current predictions around emerging markets debt for 2023 hinge on great unknowns, including the stance of China, the second largest global economy, on its Covid policy and ongoing regulation of the country’s real estate sector.

Predictions also depend on either the continuance or the cessation of the Russian war in the Ukraine and the stability of various sovereign entities.

The outlook is somewhat dim on local-currency debt with many bankers preferring hard currency debt in the current environment of a strengthening U.S. dollar.

China property developers

When 2021 was shutting down for the year, the imminent collapse of China Evergrande Group was just starting to loom on the horizon.

The possibility of a sizable bankruptcy from the group cast a shadow on other Chinese property developers including Kaisa Group Holdings Ltd., Modern Land (China) Co. Ltd. and Sinic Holdings (Group) Co. Ltd.

At the end of 2022, one year later, Evergrande has a rescheduled petition hearing supposedly in March 2023, but the date has been pushed with a restructuring plan promised for months, ever imminent, not yet delivered.

As of October 2022, Kaisa said it was working with its financial adviser Houlihan Lokey (China) Ltd. to assess the company’s capital structure and “evaluate the liquidity of the group,” according to a quarterly update from the company. Kaisa was working with holders of its dollar notes to ease its liquidity issue and to formulate a potential restructuring.

Modern Land (China) fell apart by midyear and has been working on a restructuring.

As of September, Sinic’s situation was not rosy. The company had failed to file results for the year ended Dec. 31, 2021 or results for the first six months through June 20, 2022. There were overdue payments and the company was working with a legal adviser and financial adviser. The company’s shares and debt securities had been suspended for an entire year when the company issued its update.

Helen Qiao, chief greater China economist and head of Asia economics research for BofA Global Research, says it this way, when talking about the property market in China in 2022, “The downturn started in 2021, when policymakers concerned about ever-rising property prices significantly tightened funding policies.”

“This created a crippling liquidity crunch for private developers, many of whom were highly leveraged. Buyers lost confidence in developers, leading to a drop in sales and construction. All of this in turn affected sales of construction materials such as steel and glass, electronic appliances and other goods and services,” she continued.

“Property, which had long been a major contributor to China’s economy, became a drag on growth in 2022,” Qiao said.

Property developers 2023

Investment bankers are showcasing hope, though, that China has now realized it overtightened its restrictive lending practices and regulatory environment for its property developers and is backtracking on some of its policies.

Henk Potts, market strategist for EMEA for Barclays, noted the “Chinese property sector accounts for around 25% of GDP when construction, land sales, and other related activity are taken into consideration.”

It is generally thought that the Chinese government will now move to loosen its policy and better support the industry in 2023.

BofA’s Qiao says that regulators are finally starting to step up their efforts to support financing for private developers.

She said that the overtightening that led to the crisis has already been erased, in BofA’s view, and that “The property market may not return to growth in 2023, but these developments suggest it will no longer be a major drag on the economy.”

China on Covid

China also needs to loosen restrictions in another sector, though: Covid.

To that end, after protests, the government has dramatically reversed course on its zero-Covid policy which had citizens in lockdown for the better part of the past year.

About the reversal and the end of zero-Covid, Michael Hartnett, chief investment strategist for BofA Global Research, posits that “Emerging markets are clearly dominated by China, so the primary reason to be overweight in emerging markets is if you believe the Chinese reopening story is going to be as bullish as what happened in Europe and the U.S. in 2020 and 2021.”

He says, “If that happens in China, which has a lot of excess savings that people are going to want to spend as the economy reopens, that’s a simple and very powerful story.”

War

Russia’s invasion of the Ukraine started in late February.

The subsequent war meant that the largest liability management story of the year, in terms of dollar value, was the vast and complete restructuring of sovereign Ukraine’s debt.

Outside of the massive restructuring, which did not include any defaults, HSBC noted in its first-quarter 2023 outlook that the highest default rate for EM was currently unsurprisingly coming out of EM Europe, tracked at 21.7% (compared to 12.8% for Asia).

Since the war altered Europe’s energy supply, the fear that defaults would spread based on oil costs seems to be abating.

The colder parts of Europe seem to be currently weathering the higher price of oil and absorbing the stress of that inflationary arena.

Sovereigns

As of the end of October 2022, EM sovereign bonds had a negative return of 23.8% for the year, according to HSBC.

Goldman Sachs Asset Managements’ Kay Haigh noted that “Certain lower-rated EM economies have already lost access to external bond markets, challenging their ability to meet near-term external and fiscal needs, and repay upcoming debt maturities.”

“Looking ahead, from the perspective of currency reserves relative to external financing needs, Pakistan, Sri Lanka, Bolivia, Argentina, Angola and Egypt are among the most vulnerable. From the perspective of high debt loads and high-debt servicing costs, Egypt, Ghana, Sri Lanka, Ukraine and Zambia are among the most challenged,” the head of emerging market debt continued, when asked which economies are struggling to raise capital.

When asked if an EM crisis was looming for 2023, Haigh pointed out this was unlikely because, “Excluding sovereigns in distress, EM sovereign bond spreads are broadly unchanged year to date and have outperformed similarly rated U.S. corporate bond spreads. [Goldman] believe this reflects economic resilience among middle-income, often larger, EM sovereigns.”

“For example, the five largest countries in the external emerging market debt index by GDP – Brazil, China, India, Indonesia and Mexico – do not appear at risk of an external crisis,” Haigh said.

HSBC also sees low risk with some of the larger economies. In terms of asset allocation, it recommends remaining selective, focusing on cash-rich companies with low refinancing risks and keeping diversification in mind.

On a regional basis HSBC prefers Brazil, Mexico and the Arab States of the Gulf, which have demonstrated more economic resilience in the current global environment.

FX

A strengthening dollar may well impact emerging markets debt.

Many banks pointed to a current preference for hard currency debt over local currency debt, even though as HSBC reported, EM local bonds were more resilient than hard currency debt issues in 2022, declining by 9.5% on average versus the negative 23.8% for sovereigns noted above and negative 19.8% for hard currency corporates.

However, including FX weakness, hard currency and local currency provided quite similar negative returns of 19.3% in U.S. dollar terms.

Asset manager Macquarie, for example, says the firm is cautious on “EM foreign exchange (FX) exposure as U.S. dollar strength continues to be the key driver, [though it] recognizes valuations are attractive.”

Barclays’ head of fixed income strategy, Michel Vernier, says that the strengthening U.S. dollar “has already led to significant outflows from this part of the bond market, as carry trades became increasingly less attractive.”

He says that 2023 “should bring similar challenges, as some emerging markets are faced with a worryingly weak currency already.”

Vernier notes some risk in that there are “lower dollar reserves, with less headroom to counteract any further dollar-imported inflation, and limited fiscal leeway.”

However, he says that 2023 could be a turning point.

“If U.S. policy rates peak, and if the market starts to price lower rates for 2024 or 2025, emerging market debt could stage a comeback,” he outlined as a positive possibility for 2023.

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