After a year of war in Ukraine, there have been lessons aplenty for the bond markets. One of them is that the bogeyman of contagion across emerging markets — largely regarded as a myth in these modern, more educated times — does in fact exist, under the right conditions.
After the 2008 financial crisis, EM investors and bankers were fond of trotting out the line that EM contagion was nothing to worry about anymore. And in its basic, older, form, for many years they were mostly right.
The concerns of old were largely that there was not enough education for investors to differentiate between credits in a particularly sophisticated way and the asset class was not big enough to withstand shocks. The fear was, simply put, that should there be a problem in, say, Nigeria, people would sell Kenya because they were both in Africa — despite the countries being fundamentally different economically, with no links in government.
As the asset class and its history grew, EM countries were no longer seen as one entity. Steady Russia, before it annexed Crimea in 2014, was no longer thought of as the same risk as Kazakhstan, with its defaulting banks. Saudi Arabia with its oil was not Dubai with its tourism.
With a bigger asset class and more names in the main EM indices, investors could be pickier about what they bought and, crucially, about what they sold in times of stress. The links between credits seemed looser and more tenuous.
But then came 2022.
While EM credits have sold off to different extents since the war in Ukraine began, the interconnectedness of the countries that issued the bonds — and indeed the wider world — has been laid bare. Not only through trade links, but through politics as well.
The US and Europe’s sanctions on Russia were so severe — and investors lost so much money as a result — that buyers needed to rapidly reassess not just what they thought of a country’s financial strength, but also what those superpowers thought of the geopolitics of individual countries.
China’s relationship with Taiwan was suddenly a concern, for example. Turkey’s relationship with Russia too, for fear of secondary sanctions.
This new concern was marketed from funds as a wake-up call around ESG. However, it was also a fresher investment strategy that looked at the bottom line and the new risks.
Russia was still thought of decidedly as an EM country in 2022. But it was a large, powerful one and important too in terms of energy supplies. Cutting it off from the global financial markets — which was very much the intention of the sanctions — had repercussions in terms of global energy prices and inflation.
Aside from Ukraine, the first countries to feel the financial strain of the war — and the sanctions — were Russia and Ukraine’s CEE neighbours. Their main trading partner had essentially vanished and their energy costs rocketed. In addition, many of them were now dealing with the pressure of huge numbers of Ukrainian refugees.
CEE countries whose finances previously seemed to operate very independently suddenly all had the same problem — one that was not of their own making.
But wider EM suffered too as global inflation soared — and so did local and developed market interest rates. Some were affected much more severely than others, but even the yields of oil-producing countries in the Gulf rose.
Some argue that it is unfair to call what we have seen in the past year contagion within EM, as it was in fact a global problem that affected all corners of the markets. But it was caused by an EM country and EM countries have been worst affected. They continue to bear the strain not just of increased interest rates — like the rest of the world — but also of many investors’ views having profoundly changed in terms of the risks of dealing with this asset class.
In the past year EM contagion has not been the knee-jerk response of old. It has been a considered response to the war. But nevertheless, it has proved that it exists.