Last week, several members of our Emerging Markets Debt (EMD) team attended official and private sector sessions at the annual International Monetary Fund meeting in Washington, DC, where the mood was decidedly subdued. The issue? Dark clouds hanging over the market due to the threat of sizable tariffs that could be at odds with the current global, rules-based cooperation model. In our view, such tariffs could pose a real risk for emerging markets, given the latter’s dependence on global trade; moreover, potentially inflationary effects could push interest rates higher, tightening financial conditions and further burdening countries with low growth or higher dependence on market funding.
Fortunately, the role of the multilateral organizations like the World Bank and IMF has become more material, providing a backstop for challenges that could arise in such a scenario. The engagement of the multilateral development banks (MDBs) with the private sector is also continuing in light of the need to scale up climate transition finance. This market has become quite varied, with financial instruments including outcome, debt-for-nature, sustainability and green-linked bonds. As long as such vehicles are relatively liquid and investment grade, the ability to appeal to mainstream investors should remain intact. That said, standardization has been elusive, given the multidimensional aspects of focus areas around climate change, sustainable development goals and, especially, biodiversity. More basically, private sector participation in EM infrastructure may remain limited given limits imposed by strategic asset allocations on EM investments (let alone illiquid EM infrastructure investments). Efforts are underway to allow mainstream investors to participate, shielded by the preferred creditor status of MDBs, which would make such exposure at or near investment grade, but conversations are still preliminary.
On a brighter note, we are watching various promising turnarounds in individual emerging markets, whether Zambia, Sri Lanka or Argentina. This has led to a trend of credit upgrades across the EM universe, and, international conditions permitting, would potentially allow for performance strength in a tight credit-spread environment. This could be the silver lining for EMD investors.
