EM economies should accelerate thanks to improving foreign trade and strong commodity prices; however, they may face much more challenging conditions in 2022, according to Mr Paseniuk.
Global economic outlook
The global economic outlook remains promising despite inflation fears and rising US Treasury yields undermining financial market sentiment, according to Mr Makar Paseniuk, co-Founder of ICU, an independent asset management, private equity and investment advisory firm specialising in the emerging markets of Central and Eastern Europe.
Despite global mobility restrictions generally easing only marginally since the beginning of the year, the pace of vaccinations is encouraging. Taking Israel as an example, Mr Paseniuk points out that a high percentage of vaccinations does result in rapidly restoring mobility and business activity.
The global forecast for GDP growth keeps being revised up and is currently at 5.5 – 7% in 2021, and 4 – 4.5% in 2022. However, Mr Paseniuk believes that this forecast is subject to significant uncertainties relating to the efficacy of vaccines with new COVID-19 strains, effectiveness of policy actions, economies’ adaptability, and financial markets.
Moreover, the speed of recovery will substantially differ across regions, countries, and economic sectors. “Most likely, the US and China will lead the recovery, while EU and emerging markets will lag behind,” according to Mr Paseniuk.
Emerging markets economic outlook
Despite having lower access to vaccines, Mr Paseniuk believes that most emerging markets should experience accelerating economic growth, driven by vaccinations in AEs, stronger demand for EM exports from Advanced Economies (‘AEs’), and high commodity prices.
However, the policy making in EMs is already becoming unsupportive as a number of EM central banks have hiked key policy rates. Mr Paseniuk expects policy tightening to continue in 2H21, strengthened by policy in China starting to normalize.
Slowing China credit stimulus will also be a strong headwind to commodity prices. Higher US Treasury yields, a stronger US dollar, weaker commodity prices, and more market fears about a coming ‘Taper Tantrum-2’ may create a much more challenging environment for EMs, including Ukraine, in 2H21 and 2022.
Tightening global financial conditions
“While high inflation will be transitory in most countries, there is a significant risk that high inflation will continue to persist in the US due to a tighter labour market and the Fed’s more inflation-tolerant approach compared with other central banks,” says Makar Paseniuk.
The US is currently on a path of fast economic recovery and job gains. Mr Paseniuk expects this to potentially result in the curtailing of Fed asset purchases and hiking rates sooner than expected. A similar turnaround in Fed policy in 2013 resulted in a spike in US Treasury yields and a sell-off in risky assets including EM credit in a market-panic reaction dubbed the ‘Taper Tantrum’. While the US central bank’s policy normalization will be more cautious this time, Mr Paseniuk believes the likelihood of ‘Taper Tantrum 2’ has been enhanced by unprecedented capital inflows into commodities, equities, and EMs.
The impact of tightening global finance conditions on Ukraine
“While the IMF recently dismissed rising concerns over higher inflation and interest rates in AEs spilling over to tighter financial conditions in EM/FM, we do not rule out such a scenario completely”, says Mr Paseniuk. Realisation of higher inflation in the US and worsening inflation expectations may fuel the trend of rising US Treasury yields to run further and support the US dollar.
Mr Paseniuk expects that this would weigh on commodity prices and diminish attractiveness of risky assets competing with US Treasuries including commodities, EM equities, and EM debt instruments. As a result, EMs which are most dependent on external financing and commodity trade, will become more vulnerable.
“We assume that if the current tightening of global financial conditions persists, it could lead to a wider divergence between riskier EMs and their more stable peers. Unfortunately, it seems that Ukraine tilts more to the first group; however, it is not among the most vulnerable economies in terms of external liquidity or balance-of-payments pressure,” explains Makar Paseniuk.
Mr Paseniuk points out that Ukraine has a relatively moderate public debt burden, especially assuming fiscal consolidation planned this and next year. However, liquidity risk is high as a high share of external liabilities in public debt and their prevailing short maturity determine a tough repayment schedule. Moreover, having fallen in 1Q21, international reserves are still below the minimum level of the IMF’s ARA metric.
Meanwhile, a potential IMF’s SDR allocation ($2.7bn for Ukraine) and an improved current account position evidence lowering risks for external sustainability and provide some relief from potential FX market pressure. In addition, yields for Ukrainian bonds are likely to include additional premium, reflecting weak institutions and lagging structural reforms. Successful implementation of the IMF programme could lessen the risks; however, instead, weak progress with the first review creates additional concerns for investors.
Fall in export prices
A likely further increase in US Treasury yields and strengthening of the USD amid growing inflation concerns may have a significant negative impact on commodity prices in 2021 and 2022. However, even stronger headwinds may come from one of the world’s key commodity purchasers, China, according to Mr Paseniuk. In 2020, the efforts of China regulators on supporting the country’s economy from COVID-19 damage led to an acceleration of credit stimulus growth, which also spilled over to commodity markets and boosted prices for key raw materials, particularly metals.
Having gotten the pandemic under control, it no longer needs as much monetary and fiscal support, and the Chinese authorities have focused on reducing the risks of an overleveraged and overheated economy. “China’s tighter policy may offset the positive effect of the rest of the world’s economic recovery on demand for commodities, and may be further exacerbated by a sharp drop in investment demand,” says Mr Paseniuk. Across global commodities, metals are most vulnerable to China policy tightening. Stimulus withdrawal may be particularly negative for iron ore and steel, which became the top price gainers in 2020, despite the world economic recession.
Ukraine’s exposure to external commodity trade is one of the highest among EMs, both on the imports and exports side. “Around 60?70% of Ukrainian exports are highly dependent on commodity markets of steel, ore, and agri products. At the same time, at least 30% of Ukrainian imports depend on the prices of energy resources such as natural gas, oil, and coal”, Makar Paseniuk explains.
Ultimately the COVID-19 crisis played in favour of Ukraine’s highly commoditized trade in 2020, as a sharp drop in imported energy prices was accompanied by much more moderate decline or even growth in prices of exported metals and agri products.
“As a result of contraction of export proceeds and trade deficit expansion, we will see a decline in domestic demand and additional pressure on the FX market. Moreover, fiscal performance may deteriorate sizably as well due to the high share of foreign-trade related revenues in the overall amount,” says Mr Paseniuk. Therefore, while currently there are mostly positive externalities from global commodities prices on the Ukrainian economy, risks are rising, and they are tilted to the downside in the short and medium term.
