As markets digest the impact of Silicon Valley Bank's (SVB) failure (and subsequent rescue over the weekend), investor focus will likely turn to vulnerabilities in other Developed Market banks and to those seen as most exposed in the event of major unexpected deposit withdrawals. Still, barring perhaps some specific cases, contagion risks are seen as limited and few expect a wider systemic banking crisis at this stage (perhaps in part due to the quick reaction of US banking regulators). Meanwhile, for our thoughts on the impact on Emerging Market banks, see here.
Here, we set out our initial thoughts on the implications for Emerging Market sovereigns.
We see the initial impact as being felt mainly through EM funding conditions (rather than through any real economy impact at this still early stage).
So far, one immediate impact is more dovish interest rate expectations in the US. The market now expects a lower US interest rate path (and lower terminal rate) with Fed Funds futures pricing out 50bps of rate increases by June 2023, so that only one more 25bps hike is seen instead of three (taking the policy rate to 5% instead of 5.5%, from 4.5-4.75% currently).
US bond yields have also fallen in a flight to safety (and perhaps also due to Friday's mixed NFP data), with the 10-year down 20bps to 3.70% by cob Friday, its lowest level for some four weeks (and down 30bps since cob Wednesday). The 10-year has fallen a further 23bps this morning, with the yield of 3.46% the lowest since early February and testing a key support level.
Meanwhile, reflecting the more dovish rate expectations, the 2yr yield has fallen 49bps this morning to 4.09%, having fallen by 28bps on Friday, and is down c100bps since cob Wednesday.
However, despite the "benefit" of lower US rates and a lower risk free rate, we think market uncertainty may lead to a risk off environment and a flight to safety (and a stronger dollar), which will be negative for risk assets, including EM sovereign bonds, at least in the near term. This could see a rise in EM spreads.
We note the VIX has already picked up, which is negative for EM risk. The VIX volatility index has seen an increase to 25pts by cob Friday, and has risen another 5pts this morning to 30pts, and there is a strong correlation between EM spreads and the VIX. The last time the VIX was at these level was in the depth of the market sell-off last October. But the VIX is still below other key episodes of market stress.
As a foretaste, the spread on the Bloomberg EM Sovereign USD index rose 15bps on Friday, to 420bps, its highest level since November.
It is therefore early stages, and sentiment could ease with the global policy response, but against this backdrop, we think the most vulnerable countries are those with large funding needs (relative to reserves), especially if any have to cancel issuance plans due to market conditions, those that rely more on short-term foreign capital flows for funding (eg Kenya), and/or those with low or declining reserves which are less able to withstand a sudden stop in capital flows (eg Bolivia). Countries (such as El Salvador, Ecuador, Bahamas and Maldives) where there is already a lack of visibility over funding may also suffer (tighter global credit conditions, either due to lower availability and/or higher cost, will only add to their funding uncertainty).
Conversely, countries with adequate reserves coverage and/or more funding flexibility will be less vulnerable in these conditions (eg Uzbekistan, Kazakhstan). Similarly, the GCC may be less exposed given the strength of sovereign balance sheets in the region and the defensive portfolio position they provide (low beta).
More generally, our external liquidity index identifies those countries that are more (or less) vulnerable to a sudden stop in capital flows (balance of payments crisis). The most vulnerable (excluding those in default) are Mozambique, Ethiopia, Pakistan, Bolivia, Mongolia and Tunisia. The least vulnerable are Kuwait, Saudi Arabia, Papua New Guinea, Iraq, Azerbaijan and Peru.
