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The Impending Wave of Emerging Market Defaults

A former Elliot Management fund manager explains to Bloomberg that he explains a wave of emerging market defaults (see link to Bloomberg article below). We agree and explain the structural reasons this is likely to happen and to be a pervasive problem.

Emerging Markets is one of the asset classes that we have highlighted to the litigation community as meeting our criteria of fertile plains for impending disputes: namely they are likely to incur losses and defaults, and there is significant opacity of contract, between the various jurisdictions and the complexity derivatives and instruments used in modern finance.. 

The primary challenge faced by Emerging Markets economies is one of competitiveness. Since World War II, the economic landscape of the world has been built upon the Washington Consensus. A frame-work of international commerce (backed by the World Bank and the International Monetary Fund) that encourages international trade and investment. 

Under this framework, the rule of law is the basic building block of an economic system. With the rule of law comes property rights. Property is the asset that most loans in the banking system are collateralised by, and so contributes materially to the base value of the Fiat currency of the system (as currency is created with each loan, so high quality loans means the money created is based on something real in the economy). 

Secondly, the system is built on ideas of economic trade set out in The Wealth of Nations, by Adam Smith, and under this system countries are rewarded for excellence in the production of a few sectors as opposed to mediocrity in many. 

Smith explains that countries, for example, Britain and Portugal, capable of producing the same goods, let us say port and steam trains, should focus on producing what they are better at. Even though both countries are capable of producing both goods, it is preferable for each to produce what it can make most efficiently and purchase the other item from the other country. This means that resources are always focused on what that country is excellent at, and so it is most competitive globally. It is no coincidence that the countries that have joined the top table (at least in terms of GDP per capita) are those with whom we associate excellence in certain fields. Taiwan, Japan, South Korea, Singapore each have industries that are at the top of their game globally. 

By contrast, as difficult economic conditions loom, the nationalist voices in emerging markets engage with ideas like ‘self-sufficiency’. In essence, make more stuff at home, in a bid to save precious hard currency. The trouble with that is that most countries have items they need to import, like oil (or petrol), food and essential goods (clothes, computers, etc). 

To make this abstract idea more concrete, let’s imagine that your postcode (usually just a street) became self-sufficient. Imagine all the things the people in your postcode could make and sell to the world and all the things they would need from the ‘outside world’ (the world outside your postcode). Let us also assume your postcode is full of lawyers. 

And so there are two economic ideas to consider here. First is that of self sufficiency. In that model, your citizenry, made up of lawyers, would wake up every day and farm the produce they eat, and build the computers they use, and practice very little law (as they would be busy with all the other essentials). Alternatively in the free market model, the community of lawyers would sell their legal services to the world, and use that income to buy their food and computers. This is Smith’s point. By selling what you are good at, you spend time and resources most efficiently and so gain greater benefits (as you can buy more), and others benefit from your efficiency in your field, which in this fictitious postcode, is advice about the law.

Of course the real world is less simple, in that it is more plausible for countries to be self sufficient, but in mathematics this sort of proof is called a reductio ad absurdum. I.e. by creating a ridiculous idea of a single nation on a street made up of lawyers, we can see Adam Smith's principles more clearly that when considering large countries.

A more real world example is the example of Sri Lanka. It defaulted on its bonds (in 2022) as it had run out of hard currency reserves and so could not make the dollar payments nor could it import petrol (without hard currency, you can’t pay for petrol on the international market). 

Ideally, Sri Lanka would have goods it makes that the world needs, and so earn hard currency, which it can use for the goods it needs. However, over the past forty years, and really since its independence, Sri Lanka has increasingly relied on foreign debt to finance its trade deficit. I.e. it sells less that it buys, and borrows dollars to bridge the difference. Poor economic policies (and a civil war and / or genocide against minorities) have resulted a crumbling domestic economy. 

It used to be able to export raw agricultural goods, receive hard currency from its workers abroad, and rely on tourism for hard currency, but the pandemic took its toll on all three.

The challenge for Sri Lanka is to create an economy that exports goods and services to the world that can pay for its needs. It’s blossoming IT sector, with off-shore software development, would have been one such service, however with crumbling infrastructure (from roads and railways, to a lack of petrol today), it is difficult for professionals in this sector to compete with international counterparts in India, Bangladesh, Pakistan, and other countries around the world. This is real world example a vicious cycle ensues. Today Sri Lanka is trying to convince creditors that all it needs is more debt to get back on its feet, but lenders are demanding more deep rooted reforms as they are concerned that more lending, would simply be a case of good money after bad. 

As Newman points out in the article, "developing nations face a toxic mix of higher inflation and interest rates making debt servicing harder."

To make things worse, international trends in deliberately curbing funding carbon based fuels will make traditional carbon based fuels more expensive, but these are essential imports of most countries. High value economies can more readily improve productivity. In the past this may have meant the building a public transportation networks, that use less fuel per head. Today in high value economies with the capacity for remote work it is possible to reduce travel, but low value economies are of course more vulnerable. 

Some economies in the Noughties used cheap labour as a source of income. Outsourcing to India and other developing countries allowed them to create valuable local tech economies, and so have assets that are internationally competitive. However, as local wages rose with time, increasing political pressure to bring work back on-shore and with the accelerating trend in automation, international outsourcing and labour displacement trends will also come under pressure.

Those countries with access to large pools of natural resources, like Brazil, Russia, Nigeria and others will be better off. Their commodities will earn some hard currency in exchange for the goods they need, but many emerging economies are not in that position.

There is some good news. New technologies, like Fintech and Edtech are making access to these valuable intangible resources easier to entire countries without the costly infrastructure. Mobile phone based payments are bringing banking to remote communities and with it gains in productivity. I.e. the emerging market countries benefit from the huge gains in productivity in the world as a whole, but as with all things they need to purchase them with hard currency. 

The greatest challenge at this critical juncture is domestic politics and so policy. We are already seeing the rise of the strong man politician, for whom this international system of trade is a foe to be wrestled and reckoned with. Whether it’s Erdogan in Turkey or Duterte in the Philippines, they do not buy into the fundamental free market philosophies of the Washington Consensus. 

The primacy of the rule of law, individual rights and property rights are all inextricably linked to prosperity under the Washington Consensus and the associated Fiat currency system. Emerging markets nationalist philosophies are often some combination of ‘localisation / self sufficiency’, minority / foreigner bashing and land appropriation. 

As the economic challenges rise, expect few countries to engage with the political challenges astutely. Many of the non-commodity producing countries will be the first to fall (like Sri Lanka and Pakistan), but producing commodities is insufficient, and as the cycle matures, countries like Brazil and Nigeria will follow too, as they spend their advantage poorly. Dutch Disease or the Curse of Oil, are some economic theories that show how the wealth of commodities can be, and for most countries are, easily squandered.

“What we saw there [in the 1980s] was a period in which something like 25 countries defaulted. They defaulted because markets closed to them. And that’s what typically happens. The initial defaults in Poland and in Mexico made lenders very nervous. And when it came time to roll over the debt, there were no takers," explains Newman. The post Great Financial Crisis of low interest rates created unsustainable borrowing in many asset classes, and it is likely the Emerging Markets is one of them.

It is likely that Mr Newman is right, and that there is a difficult few decades ahead for emerging markets. During the last emerging markets downturn in the 1970s and 1980s, the non commodity producers devalued and defaulted first, followed by the commodity producers. The end of the cold war in the 1990s saw a new wave of optimism flow through emerging markets, but we seem to be coming to a cyclical turning point.

Relevance to litigators
Emerging markets is one of the asset classes where we are seeing, and expect to continue seeing significant losses. Follow our series on the asset classes in distress that should provide litigators with a guide to sectors where they can expect more litigation.

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