Emerging markets outlook – Darkest before dawn

Growth headwinds in EM abound

Economic activity in emerging markets (EM) again proved more resilient than expected through most of 2022, prompting upward adjustments to GDP growth forecasts for the full year. But as we head into 2023, economic activity will be affected by the sharp tightening of financial conditions, while external demand will weaken as advanced economies are expected to slow. China is the brightest part of the EM story, but its COVID-19 re-opening path is fraught and likely to prove less of a driver for EM commodity demand than during past economic recoveries, as it is now more services-oriented.

Policy mixes will be increasingly less supportive, with central banks likely inclined to keep rates higher for longer, similar to expectations from major developed market central banks, while price indexation mechanisms may be an obstacle to disinflation. Brazilian and Hungarian central banks are likely to be the first to pivot by end-2023. Fiscal policy space has been reduced by the exceptional COVID-19 efforts. Additional measures taken to limit the inflation effect on household balance sheets will gradually be removed across 2023-24. All in all, we expect EM (excluding China) GDP growth to decelerate sharply on a sequential basis in Q4 2022 and Q1 2023, and then slowly improve into the second half of 2023 and more so in 2024 as external and domestic conditions normalise.

Rising vulnerabilities for low-income countries

The external backdrop has remained a headwind for EM countries overall, but lower-income countries, usually referred to as frontier markets, have been significantly impacted by tighter global financial conditions, reduced liquidity and a much higher reliance on external financing. In recent months, Sri Lanka suspended its foreign debt payments, Ghana is expected to restructure its debt to qualify for assistance from the International Monetary Fund, El Salvador experienced high solvency risks, Egypt is striving to cover its balance of payment gap and currency devaluations are looming in Kenya and Nigeria. More broadly, many frontier market governments are forced to rely heavily on external debt which, along with an increase in debt service costs, makes them vulnerable to currency moves which could ignite sovereign crises. Rising inflation, falling currencies and higher food import bills mean the odds of balance of payment crises are rising as the level of foreign exchange reserves become inadequate. Social unrest – linked to food insecurity – is a clear risk, that new multilateral emergency financing lines are trying to avoid.

Central and Eastern Europe in recession

High inflation is weighing on household purchasing power while tighter credit conditions will hurt fixed investment in Central and Eastern Europe, at a time when a winter energy supply crisis will be pushing Europe into recession. The timely disbursement of European funds will be critical to the growth profile. Poland and Hungary are yet to achieve the milestones imposed by the EU Commission – which could delay Poland receiving the funds until 2024 while Hungary could potentially lose 70% of the resources. However, despite the region’s forecast recession, central banks need to maintain a tight policy stance in order to anchor inflation expectations and limit currency depreciation given widening current account deficits. With fiscal tightening in sight post-2022 elections, high policy rates and severe recession ahead, Hungary is the only central bank in the region that we expect to ease policy in 2023.

Turkey likely to pivot, willingly or not

At odds with global synchronous monetary policy tightening – and all the more worrying given its high inflation, rising external financing needs and declining currency reserves – Turkey has been cutting policy rates. The currency has been supported by the central bank’s ‘liraization strategy’ which restricts capital mobility and forces banks to buy government bonds. Without a much lower energy bill or much weaker currency helping to curb the non-oil deficit, the overall current account deficit is likely to widen beyond 5% of GDP. Two-thirds of capital account financing relies on unidentified ‘net errors and omissions’ but is needed to avoid an outright currency crisis before mid-2023 elections. At that point, we believe the central bank will pivot to monetary orthodoxy, with policy rates likely raised to around 15%-20%, which should trigger a contraction in growth but also a gradual reabsorption of imbalances.