Pandemic takes toll on emerging market finances

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• The pandemic has increased populist policies in Latin America, including Chile.
• Emerging economies face downside from past tepid fiscal reform efforts.
• As expansionary fiscal policies rise and easy monetary policies ebb, the global risk-free rate will likely trend higher.

Recent economic data continues to indicate a large gap between emerging and developed economies. Many emerging-market (EM) economies continue to struggle with high Covid-19 infection rates and mobility restrictions. New variants have hit some parts of Latin America and Asia especially hard. While renewed restrictions will be a drag on activity in the second quarter, the impact will be less severe than during the first wave of the pandemic, in our view. We highlight some key themes going forward.

The intersection of populism and the pandemic in Latin America

Sustainable economic recovery remains far off in Latin America amid elevated infection rates. The pandemic has influenced not only fiscal policies but also political outcomes. Populist policies have gained support. It is getting harder for governments to establish some credibility, as they turn to utilizing fiscal and monetary support and the external backdrop becomes less supportive of emerging economies.

In Peru, the results of the June 6 elections are still being contested. Leftist candidate Pedro Castillo has won the most votes in the presidential run-off election but is facing legal challenges from right-wing rival Keiko Fujimori.

In Chile, households appear willing to eat away at their nest eggs. Lawmakers are considering a bill that will allow Chileans to withdraw their entire pension savings. The country's pension system is widely considered to be one of the best in the world, but populism seems to be putting an end to that. This will likely add to the public sector's future liabilities. In addition, Chile's center-right ruling coalition suffered a loss in mid-May elections. Voters elected a left-leaning special assembly to draft a new constitution. This may pave the way for a political agenda to increase spending. Separately, the lower house approved in May a reduction of the value-added tax for some products.

In Colombia, tax reform efforts failed to materialize, leading the Standard & Poor's rating agency to cut the country's rating to junk. While the corporate sector looks more willing to accept higher taxes to prevent another junk rating, recent anti-government protests may slow progress.

Commodity prices and fiscal policies

Many emerging economies are also key commodity exporters. Although these countries tend to outperform as commodity prices rise, they do their best when commodity price inflation is driven by demand. They do not benefit as much when a plunge in supply pushes prices higher. It is hard to be convinced a commodity super cycle is looming, even as prices appear resilient.

The state of fiscal balance sheets is another point of discussion in the EM world. As in developed countries, EM budget deficits have widened, and debt levels have risen during the pandemic. However, developed countries have central banks with credibility, older people willing to save, and international investors willing to buy. Since the early 2000s, there have been few reform efforts in EM, as many have instead ridden on China's economic ascendence and global liquidity.

Going forward, global liquidity may not contract, but the increasing role of fiscal policy — which comes with less accommodative monetary policy — is likely to raise the global risk-free rate. Relatively low growth rates and deteriorating fiscal finances do not make many EM countries attractive to investors. Countries with disciplined fiscal and/or monetary policymakers can still attract foreign capital. But weak growth and the required policy discipline have highlighted social issues. In addition, over the medium term, rising U.S. interest rates will continue to pressure EM central banks, especially those in countries that depend on external flows.

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