Mitigating EM public debt threats

The landscape of emerging market (EM) debt has seen a significant transformation in recent years, with foreign investors altering their appetite for these markets. Lucila Bonilla, the Global EM Economist at Oxford Economist Africa, sheds light on the major drivers behind this shift in a recent interview with CNBC Africa. A notable change in investor behavior has been observed over the past three years, as many investors have opted for safer investments with higher returns, such as U.S. Treasury markets. This preference for safer assets has led to a decreased interest in EM debt, raising concerns about the future of these markets. Bonilla discusses whether these changes are structural or cyclical in nature and offers insights into the evolving composition of public debt. Since the onset of supply shocks in 2019, triggered by events like the COVID-19 pandemic and Russia's invasion of Ukraine, EM debt has risen substantially by an average of nine percentage points of GDP. Despite this spike in debt levels, there has been a shift towards a safer creditor composition, which helps mitigate risks to some extent. Bonilla highlights a key metric called risk-weighted debt, which provides a more accurate assessment of debt vulnerability by considering potential capital flight from foreign investors amidst changing external funding conditions. Foreign non-bank entities and hedge funds, often seen as flighty creditors, have reduced their holdings of EM debt in various countries by an average of three percentage points. In economies like South Africa, Mexico, Indonesia, and Argentina, this decline has been even more pronounced at over eight percentage points. This trend has resulted in a safer debt composition, as domestic banks and non-banks have stepped in to fund government deficits, filling the gap left by foreign investors. While the increased debt levels in EMs raise concerns, the shift in creditor composition towards domestic players has created a more stable financial environment. Domestic investors in markets like South Africa have been compelled to increase their participation, despite the existing economic challenges in the country. Bonilla emphasizes a structural trend in which EM financial markets are deepening, allowing local institutions to play a more significant role in funding deficits. Looking ahead, Bonilla discusses the outlook for EM markets in the coming year. She highlights Latin America and Central Eastern Europe as regions that have shown resilience due to proactive central bank policies. These economies remain attractive for investors, along with certain Asian markets where central banks are diligently monitoring FX risks. Countries like Mexico, Brazil, Indonesia, and potentially South Africa are expected to continue garnering investor favor, depending on factors like fiscal sustainability and market sentiment. In conclusion, the changing dynamics of foreign investor appetite for EM debt underscore the importance of a balanced and diversified approach to investment. While challenges persist, opportunities exist for EM markets to regain momentum and attract investor interest through prudent policy measures and structural reforms.