Emerging market risks rise

Recent months have seen increased volatility in emerging markets as foreign investors pull back from heavily indebted countries like Turkey, Argentina and South Africa. While a full-blown debt crisis looks unlikely, political risk in emerging markets is expected to heighten, driving increased demand for specialist trade credit insurance.

With rising interest rates in the US, emerging markets have been finding it harder to service US-denominated debt. Concerns came to a head during the summer as Turkey and Argentina saw the values of their currencies tumble, stoking fears of contagion. Emerging-market assets have suffered the longest sell-off since the 2008 financial crisis, according to Bloomberg.

“We are watching carefully a number of emerging markets, including Argentina and Turkey, to understand the immediate economic effects of capital flight and how governments respond to finance their debt and stem the flow,” said Roddy Barnett, political risk underwriter at Lloyd’s insurer Beazley. A number of countries are vulnerable to capital outflows, including Pakistan and some Sub Saharan African countries like Zambia and South Africa, he said.

Short term, the outflow of foreign investment into emerging markets will create increased credit risk for investors and companies with interests in certain emerging markets, according to Mr Barnett. Longer term, there could be secondary risks, such as civil unrest or government action against foreign investors, he said.

For example, countries affected by capital outflows could seek to grab a greater share of foreign companies’ revenues, by renegotiating concessions and licences, or raising taxes. They may also try to stem the flow of hard currency leaving the country, which could limit companies’ ability to repatriate profits, or lead to non-payment of foreign suppliers.

“The direction of travel is for an increased risk [of non-payment] in markets like Argentina and Turkey,” said Mr Barnett. “Perhaps of more relevance for companies investing in emerging markets, are the potential knock-on effects as countries respond to a debt crisis,” he said.

Ireland-based packaging group Smurfit Kappa recently wrote off a €60m investment in a Venezuelan paper mill after the Latin American country seized control of its subsidiary, SKCV. Last year, General Motors took a $100m hit when authorities seized its manufacturing facilities in Venezuela.

The impact on political risk, in particular confiscation or expropriation risks, will vary depending on the country. The risk of tighter capital controls could be an even more relevant threat for foreign companies, according to Michael Henderson, chief economist at Verisk Maplecroft.

“I think the more important consideration for businesses is that balance-of-payments problems in emerging markets create the temptation for new or tighter capital controls. It goes without saying that these types of policies tend to be disruptive for multinational companies and push up operating costs,” he said.

If a country’s economic and political outlook worsens, its debt-servicing capacity deteriorates. The country will then be more likely to default because its ability to fulfil obligations decreases and relative cost of repayment increases, explained Felix Von Studnitz, reinsurance specialist at Axco Insurance Information Services (Axco).

“This will have implications for foreign corporates doing business with local partners. For instance, the time it takes for a client company or buyer of goods and services to pay its invoices to the supplier may increase significantly. This would lead to an increase in credit risk due to the heightened probability of default, such as the non-payment of invoices by a foreign business partner due to a lack of payment capacity,” he said.

In recent years, there has been an increase in the risk of non-payment in developing and emerging markets, especially after the downturn of commodity prices in late 2014. “It should be noted that since early 2018, prices in key commodity markets went down again,” said Mr Studnitz.

While Argentina and Turkey have hit the headlines with their debt problems, a full-blown emerging-market debt crisis is far from certain, according to Mr Barnett. He noted that many emerging markets have growing populations and growth potential that supports foreign investment, such as in energy, utilities, renewables, transport and telecommunications. At the same time, emerging markets are in much better shape than they were during the 1980s and 1990s, when Latin America and Asia were last hit by major debt crises.

Mr Henderson also believes that a global debt crisis looks unlikely.

“We wouldn’t want to downplay the challenges facing emerging markets, but talk of a wave of crises is exaggerated. The reality is much more nuanced. There are some countries for whom the next few years are going to be tough going, and debt is of course a key component in that prognosis. However, we’re not anticipating some kind of systemic emerging-market crisis. The fundamentals just don’t warrant that,” he said.

“I think we’re only just seeing the start of the next leg down for emerging markets. Earlier this year we predicted an environment of much slower growth and a bear market for the developing world, and this is now playing out. I’m sure we’ll see more countries going ‘cap in hand’ to the IMF or seeking financial assistance from alternative external sources,” said Mr Henderson.

An escalating trade dispute between the US and China also adds volatility to political risks. The tit-for-tat tariff increases could dent world trade, and longer term might lead to targeted action against US companies operating in China, said Mr Barnett.

A recent report from Willis Towers Watson found that the threat of an emerging-market debt crisis had risen up its political risk rankings, sitting just below the top concern of protectionism and US sanctions policy. Willis’s 2018 Political Risk Survey also found that 55% of organisations with revenues greater than $1bn had experienced at least one political risk loss exceeding $100m.

The prospect of long-term opportunities for foreign investors and companies in emerging markets has to be weighed against the current increased risk of non-payment, explained Mr Barnett. This situation could help drive interest in political risk insurance. Beazley has already experienced increased demand for cover related to Turkey in the past 12 months, he said.

Heightened instability in emerging markets, as well as the return of political risks in developed economies, will probably lead to a surge in demand for political risk and trade credit insurance, according to Mr Von Studnitz.

In particular, the fluctuation of currency exchanges in key emerging markets could see demand for currency inconvertibility coverage continue to grow, said Alexander Frost, head of global risk intelligence and data at Axco. According to Willis, the most frequently reported political risk loss during the past year was exchange transfer, which impacted nearly 60% of political risk losses. This compares with 25% for expropriation losses.

“This kind of coverage will probably be taken up in a number of emerging markets this year, as longstanding structural economic issues are exacerbated by the US Federal Reserve’s decision to continue raising interest rates, which prompts capital to flow back to the United States and knocks local currencies,” said Mr Frost.

Adding: “We expect businesses contracting in Argentina – where attempts by the central bank to stem the devaluation of the peso by raising the base interest rate to 60% has still not really reassured investors – to be particularly active in purchasing this coverage. The fear obviously being that the government may impose currency controls as the supply of US dollars is used up, making it difficult for multinationals and trading bodies to repatriate profits.”

As yet, the effect of rising US interest rates on emerging markets has not generated claims for the political risk insurance market. However, an increase in claims might be expected if more fragile economies fail to come up with sustainable plans to address debt and capital outflows, according to Mr Barnett.

Mr Von Studnitz also believes that a deterioration in emerging markets would generate claims for insurers. “At least in theory, both political risk insurance and trade credit insurance could potentially be impacted on a broad level,” he said.