The first half of 2023 will be challenging for emerging markets, but lower inflation and China’s reopening will likely present opportunities for growth in the second half.
Pandemic-related supply chain disruptions and changes to consumer preferences caused global inflation to surge in 2021. Eastern Europe, Latin America, and parts of Africa experienced some of the worst inflation in 2022 (figure 1). Chile, Brazil, Poland, Czechia, and Nigeria had all started 2022 with core inflation above 7% on a year-ago basis.1 Then came Russia’s invasion of Ukraine in early 2022, which exacerbated inflation further as the supply of food, energy, and other commodities coming from the region was cut off. In addition, the Fed began hiking interest rates, which weakened emerging market currencies. Many emerging market central banks implemented their own rate hikes to prevent further currency depreciation and restrain inflation.
Although central banks in many emerging market countries responded relatively early to inflationary pressures, price growth continued to accelerate over much of 2022. Fortunately, some of those price pressures have eased more recently, particularly in Brazil, Chile, and Czechia.2 As a result, the central banks in these three countries were able to keep rates on hold in Q4 2022.3 Disinflation in Latin America and Eastern Europe has been a welcome development. However, excessive government spending and a flare-up in the Ukraine war or energy markets could easily exacerbate price pressures again. New government administrations in both Chile4 and Brazil5 have large social-spending ambitions that could reverse progress on inflation. In Eastern Europe, the biggest risk stems from the war in Ukraine and the possibility that energy prices will rise again.
By contrast, emerging Asian economies had faced more limited inflationary pressure last year (figure 1). Each of the ASEAN-6 countries, Vietnam, Indonesia, the Philippines, Singapore, Malaysia, and Thailand, had less than 3% core inflation in January 2022.6 Pandemic-related restrictions endured through much of the year, including in China and Japan, limiting demand-side pressures to inflation. More recently, inflation in the region has picked up a little as demand rebounded and supply-side price shocks—such as higher energy bills—fed through to the prices of other goods and services. Even so, core inflation in Asia has continued to run much lower than in other emerging market countries. For example, the Philippines had the fastest core inflation of the ASEAN-6 countries at 5.9% year over year in December.7 Brazil, Chile, Colombia, and Peru all had higher core inflation over the same period. Core inflation throughout eastern Europe was far higher.
Regardless of the timing of accelerating price pressures, consumers across emerging market countries are either slowing or outright cutting the pace of their spending. Inflation-adjusted retail sales in Chile and Czechia consistently fell during the second half of 2022 on a year-ago basis.8 By Q4 2022, real spending had slowed dramatically across a wide set of countries. Spending declined marginally on a year-ago basis in Thailand in October, while it was up just 0.1% in Indonesia for December.9 The slowdown in consumer spending comes despite the government extending support to households. The governments of Hungary, Czechia, the Philippines, Indonesia, Chile, and Brazil have all implemented policies to alleviate the rise in the cost of living.10
Risk of major default remains muted for now.
As interest rates rise, many governments provide additional support to consumers, and domestic and external demand wanes, concerns over government finances have come to the fore. After all, previous episodes of global monetary tightening have ended poorly for emerging markets. Fixed exchange rates and excessive external debt, especially when denominated in foreign currencies, created a raft of defaults during the Latin American debt crisis in the 1980s and the Asian Financial crisis in the 1990s.11 Today, external debt positions have improved in these countries, and most emerging market currencies have been allowed to float. For example, Thailand’s external debt as a share of GDP is less than half what it was in the late 1990s, and the Thai baht has been a floating currency since the Asian Financial crisis in 1997.12
Despite the general improvement in emerging market finances, a handful of smaller emerging market countries have run into fiscal trouble. For example, Sri Lanka and Ghana have already defaulted.13 The stress in these countries shows up clearly in the interest rates of their government bonds and in their exchange rates. Sri Lanka’s 10-year government bond spread against US treasury bonds averaged around 25 percentage points in December. That is up more than 16 percentage points from its 2019 average. In Ghana, things look even worse, with the spread on 10-year government bonds ballooning to 42 percentage points, more than double the spread in 2019.14
Of the larger emerging market economies, few are facing serious stress. Mexico, India, Taiwan, Thailand, and Vietnam have seen credit spreads narrow since 2019. Even in places where credit spreads have widened, the margin has been relatively slim. Chile, the Philippines, and South Africa have seen their spreads widen less than Germany’s over the same period.15 Colombia and Hungary are two exceptions. Spreads with US treasuries in these countries have widened considerably since the pandemic hit. Both countries have struggled to get their inflation under control and are running current account deficits.
Although 2022 posed a serious challenge for emerging markets looking for financing, 2023 is likely to be considerably better. However, the 2023 outlook will largely depend on what happens with interest rates and inflation in the United States. Investors expect the Fed to begin reducing rates later this year, sensing that inflation is coming down quickly.16 This would ease pressure on emerging market currencies and allow their central banks to also take a more dovish approach. Financial markets appear comfortable with this narrative, funneling money back into emerging market bonds. In just the first two weeks of this year, emerging market countries sold US$39 billion of international bonds, considerably more than the record US$26 billion raised over the same period in 2018.17 However, the Fed’s own messaging has been more hawkish than market expectations, raising the risk that financial pressures could rise again in emerging markets.
China’s abandonment of zero-tolerance COVID-19 protocols, meanwhile, could have implications for sovereign risk. The reopening of China is expected to raise commodity prices. The International Energy Agency’s 2023 forecast shows demand for oil rising faster than supply, which should lift crude oil prices, benefitting OPEC countries.18 After falling in the middle of last year, the prices of other commodities are rising again, which should support government revenue in countries such as Chile, Peru, and South Africa. However, another commodity price cycle will likely challenge government finances in net-importing countries, particularly those in eastern Europe and Asia. It could also force central banks to raise interest rates as inflation rears its ugly head again, applying additional pressure on governments with the need to borrow.
Darkening external environment
After the pandemic hit and the world shifted its demand away from shuttered services and toward spending on goods, emerging market exports soared. As the world shifts back toward services and global economic growth stalls, exports are coming back to earth. Southeast Asian countries have seen some of the strongest deceleration in exports. Malaysia, Singapore, Vietnam, Indonesia, and Thailand, all saw year-over-year export growth slip more than 10 percentage points between Q3 and Q4 of 2022. Plus, Singapore, Indonesia, and Thailand all posted outright year-ago declines in Q4. Weakness in the external environment was not limited to ASEAN countries. India, South Africa, Poland, and Chile all saw year-ago declines in exports in Q4 as well. Although Brazil’s export growth looks like it accelerated strongly in Q4, it was mostly due to base effects. Indeed, December’s exports were the lowest in 11 months.19
China’s reopening should have a larger effect on emerging market exports than just higher commodity prices. Pent-up demand in China should boost demand for exports, particularly in the second half of this year. The sharp rebound in demand should certainly help countries in Asia as China is the largest export market for Malaysia, Singapore, Indonesia, and the Philippines. However, plenty of countries farther afield, such as Brazil, Saudi Arabia, and South Africa, call China their largest export market too.21
Service exports should also rebound as China reopens. With borders virtually closed in China, tourism in Asian countries had taken a huge hit. Before the pandemic, Chinese residents accounted for more than 20% of all tourists in Vietnam, Thailand, and the Philippines, and more than 10% of all tourists in Malaysia and Singapore.22 In 2022, Chinese tourists didn’t account for more than 4% of all tourists in any of those countries, suggesting that the upswing from Chinese tourism could be substantial this year. For an economy like Thailand that relies heavily on tourism, the return of Chinese visitors would dramatically improve its economic output, which remains below its pre-pandemic peak.
The first half of 2023 will continue to present challenges for emerging markets. The risk of recession in the United States and Europe has already contributed to a weaker external environment, while China continues to struggle with the immediate aftermath of loosening COVID-19 restrictions. However, the second half of the year should be brighter. Developed economy central banks may begin to ease or at least no longer tighten monetary policy, providing relief to emerging market currencies and monetary policymakers. Meanwhile, domestic inflation is expected to come down further, which should alleviate some of the cost constraints consumers have faced. The reopening of China, however, could be a double-edged sword. Although it should foster greater demand for emerging market exports, it risks raising commodity prices, thereby exacerbating inflationary pressure just as it was beginning to ease in much of the world.
