2021: The year of emerging markets high-yield outperformance
At the outset of the pandemic, the IMF attempted to expand its SDR allocation to its member states in an effort to help developing countries to cope with the crisis and provide additional global liquidity. The Trump administration blocked this effort at the time, arguing it would boost FX reserves of rich nations that did not need the money and that it would help regimes like Venezuela and Iran. Now that the Biden administration is in charge, a consensus appears to be building up among G7 nations to approve a 500 billion US dollar SDR allocation, implying that an agreement could be reached during the IMF spring meetings. Importantly, the proposed amount would not require US congressional approval. The median country will see its FX boosted by 7.2% or 1% of GDP, but low-income countries, as well as nations with low FX reserves will benefit the most. In this piece, we explain how this SDR allocation would work in practice and show which countries have the most to gain from it.
According to the IMF, “the SDR is an international reserve asset, created by the IMF to supplement its member countries’ official reserves.” The SDR is made of a basket of the most important global currencies (USD, GBP, JPY, EUR, and RMB) and it is equivalent to ~1.44 US dollars at today’s exchange rates. The IMF can allocate additional SDR to its 199 members’ central banks proportionately to each country’s IMF quotas. This requires the approval of 85% of its members weighted by each country’s quota. This implies that the US’ 17.4% voting power is enough to block the initiative even if all others countries in the world are in favor. In August 2009, the IMF allocated SDR 204.2 billion to its members (or 319 billion US dollars at the exchange rate of the time) boosting the FX reserves of all its members when countries were reeling due to the global financial crisis.
Countries receive their allocation directly on their central banks FX reserves. A central bank of a country with balance of payment needs can sell its SDR allocation to the central bank of another IMF member wishing to accumulate FX reserves. Unlike fiat currencies issued by central banks, SDRs are not a liability for the IMF. The Fund acts as an intermediary matching SDR buyers and sellers, and in case of insufficient voluntary buyers, it can designate a member with a strong balance of payments and reserve position.
Countries whose SDR holdings are higher than their SDR allocation receive an interest remuneration, which is paid by countries whose SDR holdings are lower than their SDR allocation. The SDR interest is determined by the weighted average 3-month bond yield of each of its constituent currencies, at the time 0.064%. Thus, while it is not 100% free money, it is almost free at today’s market interest rates. Moreover, the SDR interest rate will always remain lower than any non-concessional lending a developing country can obtain, and does not constitute part of a country’s public debt because there is no obligation to maintain any amount of SDR. In other words, no need to ever repay if the SDRs are used.
The IMF quotas formula is based on a country’s nominal GDP in US dollars (30%), GDP adjusted by purchasing power parity (PPP) (20%), openness (total trade over GDP, 30%), economic volatility (15%), and international reserves (5%). It is therefore not surprising that out of the top 20 receivers of SDR allocations, 13 are large developed countries, and only one of seven EMs, namely Turkey, is in need of boosting its FX reserves.
Turkey is likely to receive 4.9 billion US dollars in new SDR allocation. This is less than 1% of Turkey’s GDP and an also below-median 5.2% of the country’s official gross FX reserves (93 billion). However, Turkey’s net FX reserves – defined by the IMF as gross reserves minus pre-defined short-term FX liabilities – are much lower at 8.7 billion as of end-2020. Thus, the SDR allocation would boost net FX reserves by 56%, which would significantly reduce Turkey’s external vulnerabilities and could improve market confidence in the sovereign.
Argentina is another large EM that would disproportionately benefit in terms of boosting its net reserves. Argentina would receive 3.3 billion US dollars out of the 500 billion in new SDR allocation, this is close to the median in terms of gross FX reserves (8.5%) and GDP (0.8%), but it would more than double its current net reserves. Using non-IMF methods that focus on liquid rather than net reserves, some analysts estimate Argentina’s net reserves are in negative territory, but we stick to the IMF’s methodology. This additional 3.3 billion, if delivered promptly, would suffice to meet 2.2 billion in debt maturities with the Paris Club that come due in May. Ironically, this may allow for a delay in a long-awaited program agreement with the IMF until after the October mid-term elections.
The potential to delay economic reforms is one of the drawbacks of blanket global aid packages like the SDR allocations. However, this does not mean the IMF should not do it. We still think the benefits of helping all emerging and developing countries far outweigh the costs of postponing necessary economic reforms in many cases and possibly helping rogue regimes in others.
Countries may receive their share of the new SDR allocation as soon as this summer if 2009 is a good guidance. It is not clear whether the SDR allocation would arrive in time to meet Argentina’s debt repayments with official creditors in May. As a reference, G20 leaders agreed to boost global liquidity via SDRs in April 2009. This was followed by the approval of the IMF executive board in July, then by the board of governors in August, and finally the allocation to member states occurred on August 28.
The inclusion of a PPP adjustment in the IMF quota formula benefits low-income countries, which typically have lower general price levels. Moreover, the quotas are not updated very frequently. The current quotas were agreed in 2010 and are effective since 2016. Therefore, countries whose economies have shrunk dramatically, like Venezuela and Lebanon, or those whose reserves have been considerably depleted, like Zambia and Suriname, will receive outsized allocations relative to their current GDP and outstanding reserves. Countries with historically high GDP volatility will also receive a larger boost. These are all welcome features of the current SDR formula that will overall benefit high-yield emerging market debt.
In the case of Venezuela, which would be the largest beneficiary in terms of GDP, the fact some IMF countries recognize president Nicolas Maduro while others recognize interim president Juan Guaidó is likely to prevent Venezuela from accessing its SDR allocation in the near future.
In the graph below, we highlight the top 20 beneficiaries of this new SDR allocation relative to their GDP and current FX reserves, excluding countries without Eurobonds.
For countries that have already defaulted on their sovereign obligations (Venezuela, Zambia and Lebanon), or have already decided to undergo a debt restructuring (Suriname), the new SDR allocation is unlikely to make a difference from creditors’ perspective. Yet, the new allocation could still serve to meet urgent balance of payment needs including paying for Covid-19 vaccines, and importing foods and medicine. FX reserves are a determinant factor in a country’s ability to meet its short-term obligations, particularly if they have lost market access. But it does not play much of a role in a debt sustainability analysis to determine a country’s long-term ability to repay its liabilities. Therefore, we think it should not make a significant difference in the estimated recovery value of defaulted bonds.
For countries that have lost market access and have large short-term external debt maturities but have not yet defaulted, the new SDR allocation can make a difference between restructuring and repaying in full. We are not suggesting that these countries should prioritize debt repayments of their citizens’ needs; on the contrary, if the sovereign’s decision is to remain current on its external debt obligations to regain market access swiftly once the crisis is over, then the new SDR allocation will serve to free resources for other balance of payment needs including health-related ones.
Sri Lanka would receive enough to meet its January 2022 Eurobond maturity. The Sri Lankan government has repeatedly said it will meet its 2021 external debt maturities, and appears to have sufficient means to do so. However, there are serious doubts about whether it will be able to repay its 2022 maturities without the support of an IMF program, which they are reluctant to engage into due to the conditionality involved, i.e. austerity. Sri Lanka is likely to receive 600 million US dollars in SDRs, which would be more than enough to repay its January 2022 Eurobond maturity. Yet, this could be another example of a potential delay of a necessary macroeconomic adjustment and likely inevitable debt restructuring. In general, it tends to be better for both debtor countries and its creditors when debt problems are addressed pre-emptively rather than procrastinated.
Small, tourism-dependent nations will get a lifeline while they wait for global tourism to recover. With global tourism still depressed and unlikely to recover until at least H2, many tourism-dependent economies are finding it difficult to finance their balance of payment needs. Belize obtained consent from bondholders to capitalize coupon payments until February 2021, in other words, the interest due in 2020 was added to the principal. The new government now intends to service its Eurobond as scheduled in 2021 hoping that tourism recovers in H2. Under the new SDR allocation, Belize would receive 30 million US dollars, which may sound like little but it is almost 1.8% of GDP and enough to cover three-quarters of its Eurobond servicing in 2021. Likewise, Barbados would receive 100 million US dollars (2% of GDP), enough to cover 122% of its 2021 external debt amortization. Seychelles would get 25 million US dollars, (also 2% of GDP) and enough to cover 58% of its external debt amortization.
Many other non-touristic but distressed nations would also get large balance of payment relief ranging from Tajikistan in Central Asia to Republic of Congo in Sub-Saharan Africa.