Commentary: Credit dislocations in emerging markets can deliver strong economic, social returns

Emerging markets private credit is positioned to deliver investors returns comparable or superior to those generated from the three major emerging markets credit dislocations of the last half century. Moreover, current and imminent emerging market credit dislocations are likely to offer a deeper and more prolonged and strategic opportunity than in developed markets.

Importantly, given the severe economic impact of COVID-19, private credit can provide much-needed capital solutions to emerging market companies under strain, helping to preserve jobs and restart economic activity.

The global financial crisis of 2008 impacted emerging markets, but emerging markets were never central to that crisis. As a result, liquidity returned quickly and the opportunity for distressed investors was relatively short-lived. The Latin American debt crisis and the Asian financial crisis offered more opportunities for emerging markets distressed investors than the GFC, but these were mostly confined to each region. By contrast, COVID-19 is a global phenomenon that has exacted a human cost and a decline in economic activity that is unprecedented in the modern era.

Developed market countries are obviously better positioned than EM countries to deal with the health-care implications of the pandemic. Similarly, advanced economies can more easily provide significant fiscal stimulus to lessen the economic shock, including to low-income workers and small- and medium-size enterprises. Moreover, central banks in developed markets have injected liquidity into financial markets and, perhaps more importantly, introduced programs to lower the risk of unintentionally bankrupting firms that have lost access to credit. It is therefore not surprising that investment-grade corporates in developed markets have already regained access to capital markets in the past two weeks.

First, it is important to recognize that EM private markets were already experiencing considerable capital shortage before COVID-19, especially outside of Asia. While easy monetary conditions in developed countries fueled inflows into EM public markets for much of the past decade, private investors have retreated from emerging markets due in large part to the failure to anticipate or mitigate the potential impact of sharply weakening currencies (the J.P. Morgan EM Currency index has declined about 45% since 2011).

COVID-19 is of course exacerbating these already tight financial conditions. Widespread shutdowns to halt the spread of the virus mean emerging markets will face lower domestic consumption and lower export revenues on top of the human toll of this crisis, with countries reliant on commodities or tourism suffering the most. Already strained governments will have to weigh the need for fiscal stimulus against the risks of looser fiscal policy, including potential rating downgrades, currency weakening, higher inflation, higher real rates and sovereign defaults.

Moreover, central banks in emerging markets lack the institutional credibility of their counterparts in developed economies to implement aggressive easing policies, which would also entail substantial macroeconomic risks. They do not have the luxury to act as buyer (lender) of last resort by, for example, purchasing corporate debt instruments. That's why financial conditions in emerging markets will likely remain exceptionally tight for a prolonged period.

In contrast to private markets, the volume of sovereign and corporate public-market debt in emerging markets has exploded in recent years, rising to $3.5 trillion in hard-currency debt in 2020 from about $2 trillion in 2013, according to J.P. Morgan. This figure jumps to well over $10 trillion if local-currency debt is included. All of this debt will need refinancing over the next few years just as macroeconomic fundamentals deteriorate and public-market investors withdraw. This suggests that much of this refinancing will require private capital.

Multilateral institutions will play an important role in helping many countries in emerging markets mitigate the human and economic costs of COVID-19. To date, more than 80 countries have requested assistance from the International Monetary Fund, which has historically insisted on fiscal austerity and tight monetary policy as a condition for providing financing. It will be interesting to see whether the IMF will relax historical prerequisites for capital, such as debt sustainability requirements, given the pandemic.

Meanwhile, development finance institutions could help mitigate the cost of COVID-19 and restore economic activity by making substantial capital available to help good companies restructure their balance sheets. These institutions have typically focused on providing growth capital rather than providing capital solutions to good companies experiencing temporary and manageable stress/distress. However, in the wake of COVID-19, efficient resolution of these problems is crucial to preserving jobs, providing companies a fresh start and restarting economic activity.

Underneath all these dynamics lie important structural reforms implemented over the past few decades to dramatically strengthen creditor rights and implement effective bankruptcy regimes in emerging market countries. While progress has been uneven, the gap between high- and low-income countries in the World Bank's strength of legal rights index has halved since 2013, and continued progress on this front should make economic growth more sustainable.

All of these factors suggest that a strategic commitment to emerging market private credit may generate attractive returns in the intermediate term, while helping to reduce the associated human and social costs of the pandemic.

John Yonemoto is CIO and co-founder of Albright Capital Management LP, Washington. This content represents the views of the author. It was submitted and edited under Pensions & Investments guidelines, but is not a product of P&I's editorial team.