(Part I) EM Credit Spreads: Unsustainable Divergence

EM sovereign and corporate credit markets have so far defied the selloff in EM equities and foreign exchange markets, but the odds of material spread widening are considerable.

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As G7 central banks have crowded out global fixed-income investors from G7 bond markets by depressing yields, investors have rotated into other segments of global fixed-income markets and bid up prices of hard-currency denominated EM sovereign and corporate bonds. Our EM strategists believe the stampede into EM credit markets has gone too far, and that these divergences between EM currencies and stocks on the one hand and EM credit markets on the other will not be sustainable.

Today, EM countries’ private sector foreign debt levels (as a share of GDP) are not lower than at the end of 1996 and early 1997, when the emerging Asian crisis commenced. This is not to argue that the EM world is headed for a similar crisis like what transpired in 1997-’98. The point is that currency depreciation raises foreign debt burdens and as such should lead to a re-pricing of credit risk – i.e., wider corporate spreads.

Although the EM public sectors’ foreign debt burden is very low, most developing nations’ fiscal positions will deteriorate going forward. This will occur because the growth slowdown will drive down corporate profits and consequently governments’ tax intake. In the meantime, political pressure to keep the population happy will lead many EM governments to loosen the fiscal purse. All in all, government debt and budget deficit dynamics will worsen, justifying higher spreads on sovereign credit.

Weaker EM growth and commodity prices also represent a menace to EM credit markets. Please see the next Insight, (Part II) EM Credit Spreads: Unsustainable Divergence.

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