Dec 1, 2021
The past few decades have been transformational for many frontier markets’ development, as a combination of Chinese lending and demand by global investors for yield has created an abundant source of finance.
Over the past 15 years, many low-income countries’ relatively clean balance sheets encouraged them to tap into Chinese loans, resulting in a surge in demand. On the supply side, China was forthcoming, having little or no prior credit exposure to these countries and facing limited competition – some of the world’s major official creditors were reluctant to return to development lending following the HIPC Initiative write-offs1, leading to a vacuum in official lending – which allowed for attractive lending terms. Even as western creditors started to open lines of credit to frontier countries, there remained a preference for Chinese loans given the ability of borrowers to source large project-based finance or collateralised loans with little scrutiny or interference on domestic political and economic policymaking.
But China is only part of the story. Since the global financial crisis, benign global financial conditions and the expansion of monetary policy easing have created a fertile ground for bond issuance by frontier markets, with their relatively attractive yields appealing to investors against a global backdrop of low/negative rates. To put this into context, thanks to reasonably low levels of debt, higher commodity prices and improving growth prospects, 42 new issuers have entered the JP Morgan EMBI (flagship hard currency EM debt index) over the past 10 years, the majority of which we consider to be frontier markets – a topic we discussed earlier this year.
Recent years have brought a shift in dynamics, with the role of Chinese loans diminishing and financial markets becoming an increasingly important source of unsecured financing (i.e., via Eurobond issuance) for frontier markets. Several factors lie behind this shift.
First, the incremental change in China’s approach to lending across frontier markets seen since 2017 was prompted by several restructurings (e.g., Sri Lanka, Ethiopia, Angola, Tajikistan, Congo and Zambia) as well as a focus on reducing moral hazard in China’s domestic market. The result has been the adoption of a more cautious approach to lending and much tougher lending conditions and contracts, which often have aggressive amortisation schedules and creditor-friendly legal clauses. In turn, this has dampened demand for Chinese loans by frontier markets.
The COVID-19 crisis has been a further catalyst for change on the frontier-market financing front. By creating a significant need for immediate liquidity relief, the pandemic has forced many frontier countries back towards multilateral institutions such as the IMF and World Bank for financial support. Furthermore, in cases where the pandemic has also generated solvency challenges, we now see increased scrutiny from both the market and multilateral partners on issues such as debt and fiscal transparency, acting as an additional hurdle to frontier markets’ excessive reliance on sometimes opaque bilateral lending.
The aftermath of the pandemic is likely to mark the start of the next chapter for frontier market financing. With risks building of a move higher in global rates as central banks tackle inflationary pressure, frontier markets will need to look to expand existing - and establish new - sources of finance to meet their development goals. Three areas will be relevant for this next phase.
1. Building out domestic savings and pension markets
The further development of local savings/bond markets will play a key role. Over the past decade, we have witnessed success stories in the form of countries taking significant steps to both grow their domestic pensions and savings markets and improve the functioning of these markets. Examples include Ghana’s creation of a defined benefit pension scheme which originally started in 2010 and has seen pension assets grow by almost 1.5% of GDP every year for last five years, allowing the country to significantly lengthen its domestic maturity schedule and rely less heavily on foreign participation. How committed and successful economies are in making/progressing these necessary reforms is an increasingly important consideration for EM debt investors.
2. Increasing support from the IMF
There is potential for a further allocation of IMF Special Drawing Rights (SDRs) by richer nations to support poorer countries – the G7 has already pledged US$100 billion in this regard to assist poorer nations as they tackle the pandemic. We see interesting developments where the IMF – through the establishment of Resilience and Sustainability Trust (RST) facility – will allow low and some middle-income countries to access cheap financing through SDRs; in certain cases, the IMF could well look to establish itself as ‘lender of first loss’ on lending facilities, creating a AAA guarantee on future debt issuance with a focus on sustainability projects.
3. Rising issuance of green/ESG bonds
The RST facility mentioned above leads us to one of the biggest implications for active investors: the growing role of ESG and ESG-linked bond issuance. A global conversation is taking place involving policymakers, the IMF and the World Bank over how to lower interest costs facing low-income countries while allowing investors to invest into the projects and parts of the economy that really matter. We are already seeing a rise in green bond issuance from countries as diverse and Egypt, Benin and Kenya, and blue bond issuance (relating to ocean conservation) from Belize and under consideration in Ecuador. These new vehicles will allow investors to play a key role in financing sustainable development. However, the lack of standardisation in terms of the structuring of these instruments means investors will need the appropriate tools to be able to assess each opportunity and monitor how their capital is being used. We are closely watching countries such as Egypt, Ghana, and even Zambia post restructuring, where our recent engagement with governments has revealed significant efforts towards creating robust ESG frameworks.
1 The World Bank, the International Monetary Fund (IMF) and other multilateral, bilateral and commercial creditors began the Heavily Indebted Poor Countries (HIPC) Initiative in 1996. https://www.worldbank.org/en/topic/debt/brief/hipc
Emerging market: These markets carry a higher risk of financial loss than more developed markets as they may have less developed legal, political, economic or other systems.
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