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What is the Russia-Ukraine war's impact on EM markets?

What is the Russia-Ukraine war's impact on EM markets?

The war in Ukraine enters its third week and the long term impact on emerging markets is a certainty. In this article, IIF looks at some EM economies.

As the Russia-Ukraine conflict continues to intensify, we have updated our EM scorecard to provide a snapshot of relative vulnerabilities across 18 major emerging market economies, with a focus on debt and ESG concerns.

Against the backdrop of heightened geopolitical tensions and rapidly rising borrowing costs, Turkey, Czech Republic, Hungary, and Poland appear particularly vulnerable to changes in global risk appetite.

By IIF’s yardstick, the Philippines, Brazil, Indonesia, India, and Colombia look better insulated than many EM peers.

On ESG metrics, South Africa, Indonesia, and the Philippines all face significant challenges, including carbon efficiency, environmental protection, and a range of social issues.

Russia/Ukraine conflict exacerbates both debt and ESG vulnerabilities: The escalation of the RussiaUkraine conflict continues to push the global economy into uncharted territory.

With western countries imposing an unprecedented array of economic and financial sanctions against Russia, the sharp recent reversal in global risk appetite will weigh on economic recovery and consumer sentiment as energy prices rise (Chart 1).

The economic and financial impact could be particularly severe for emerging market economies, particularly for those that entered this new wave of uncertainty with weaker fundamentals: the post-pandemic recovery remains incomplete and uneven for many EMs and low-income countries, government debt levels are at record highs, government borrowing needs are hovering well above pre-pandemic levels, and international investor appetite for EM securities had registered weak even before the conflict escalated.

War and economy

Where are the weak links? Given these heightened un- certanities, we have updated our EM scorecard to assess rel- ative vulnerabilities across 18 EM economies. We examine how countries rank relative to peers on 1) trade linkages with Russia and Ukraine, 2) financing needs amidst rising debt levels, 3) asset valuations, 4) reserve adequacy, and 5) ESG factors (see Annex 1 for our methodology):

Trade vulnerabilities in focus: Unsurprisingly, Turkey, Czech Republic, Hungary and Poland look to be most ex- posed to changes in risk sentiment resulting from the Rus- sia-Ukraine conflict (Chart 2). This largely reflects the close economic and trade ties these countries have with Russia and Ukraine (see EM Trade Vulnerability Heatmap), which leave them most at risk for trade disruption (Chart 3).

Long term impact

Higher borrowing costs will make it harder to meet refinancing needs—already at record highs: Latin America and Turkey face high financing needs, as proxied by short-term external debt ratios, budget and current ac- count balances.

However, Colombia and Brazil should benefit from higher commodity prices. While gross external financing is back to pre-pandemic levels for many countries, government borrowing needs remain much higher than pre-COVID, as EMs entered 2022 with record high refinancing needs—see our latest Global Debt Monitor.

With the Fed still set to raise rates despite heightened geopolitical tensions, the impact of rising USD borrowing costs for EMs is already clearly visible in international debt markets: EM sovereign Eurobond issuance amounted to some $20 billion in Jan/Feb 2022, the slowest start to the year since 2016.

Most of the issuance came from investment-grade sovereigns, with pricing activity in EM Eurobond markets coming to a halt following Russia’s invasion of Ukraine. Chile was a notable exception, tapping the international debt markets to price the world’s first-ever sovereign sustainability-linked bond in early March. Increased risk aver- sion will likely continue to weigh on EM sentiment for some time to come, adding to upward pressure on already-rising borrowing costs for many EMs.

Since the onset of the Rus- sia-Ukraine conflict, EM investment grade spreads have in- creased by some 60 basis points. The rise in EM high-yield spreads has been over 160bps, with Georgia and Egypt witnessing the sharpest rise to date (Chart 4).

Robust reserves and attractive valuations: Many EMs have large international reserves and this should help reduce volatility in FX markets in the near term. However, reserves in Turkey and Malaysia look less adequate com- pared to their peers. However, asset valuations appear rel- atively more attractive in Brazil, Chile, and Turkey (less ex- pensive valuation improves a country’s score—see annex). In contrast, valuation looks more stretched in Malaysia, the Czech Republic, and South Korea.

Conflict also affects the global climate/ESG agenda:

The Russia/Ukraine conflict clearly illustrates the im- portance of the climate/ESG agenda. Heavy reliance on car- bon-intensive economic activities leaves many EMs ex- posed to fluctuations in fossil fuel prices.

Despite some im- provements over the past decade, EMs still have substantial room to reduce their carbon footprint and thus to mobilize resources towards domestic renewable energy sources. South Africa, Indonesia, Thailand and the Philippines could benefit the most from the clean energy transition (Chart 5).

Read the full report: