By Thys Louw, portfolio manager at Ninety One
Over recent weeks, frontier debt markets have enjoyed a strong rally after being caught in the eye of the storm that raged through income markets in 2022. From lingering in the depths of the EM hard currency market return tables for most of last year, a number of these markets have soared to pole position. All 10 of the best performing countries operating in this space were frontier markets in the second quarter of 2023, with Pakistan seeing the highest returns at 42% (JP Morgan EMBI).
This more supportive external environment has undoubtedly helped by removing of some key headwinds impacting the global economy. However, within the frontier market universe, we have seen a succession of positive news around the IMF and other multilateral forms of support, as well as a significant pick-up in momentum around reform. Crucially for debt investors, these developments can provide useful signposts towards pockets of opportunity in those markets charting a more sustainable economic and financial course.
Harnessing supportive tailwinds
There are several supportive tailwinds currently at play in spurring positive developments across the frontier market universe. Leadership and policy changes undoubtedly make a major impact, such as in Nigeria, where investor sentiment has been given a major boost since President Tinubu took the helm in May. Significant steps have been made since his inauguration, with reforms fast-tracked, allowing for the removal of the costly fuel subsidy and the liberalisation of the exchange rate. Likewise, significant fiscal and monetary tightening, paired with increased multilateral support, is reducing the external and domestic imbalances at play in Kenya.
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Multilateral support is becoming an increasingly powerful influence on the direction in which these frontier markets are developing. Financial backing from these global institutions is spurring greater sustainable investment. With the Tunisian President’s reform plans recently backed by both the US and the EU, its prospects of a further deal with the IMF have now significantly improved. The long-term impact of its EU funding has also surpassed initial expectations, set to work in tandem with its recently signed migration deal to usher in a host of socioeconomic reforms.
Similarly, authorities in Pakistan recently surprised the market by agreeing to a $3bn short-term financing deal with the IMF, after revealing a programme of planned tax rises in its budget. Moreover, Paraguay’s election of former IMF economist, Santiago Peña as president in May has reinforced the country’s fiscal discipline and placed it firmly on the path to attaining investment-grade status in the medium-term.
Whether through national policy or multilateral involvement, the appetite for sustainable investment in the frontier markets is clearly gaining momentum.
Keys to the plain sailing
In the short term, various support packages from the IMF, World Bank and other multilaterals remove immediate funding concerns and, over the medium-term, conditions in the external debt market could eventually return to ‘normal’. In the long run, wide-ranging reforms are vital for putting frontier-market economies on a sustainable course.
The ability of economies to do more with less will be key here. This is becoming especially urgent as the higher rates environment is making investors more demanding, creating higher hurdles to accessing external debt markets. However, even for sovereign issuers that reform and put their economies on a more sustainable path, yields in the hard currency debt market remain prohibitively high despite the recent rally, making a broader approach to funding is essential. Here, multilateral finance and/or guarantees that link to sustainability will be increasingly important.
We can already see evidence of these sustainability-lined guarantees underway in places like Senegal, who, under a recent deal with the EU, will receive €2.5bn to help fund its energy transition. This agreement under the Just Energy Transition Partnership, together with a recent package announced by the IMF, has significantly improved the country’s external funding outlook while also putting it on a sustainable energy path. Similarly, Rwanda has secured energy transition funding under the IMF’s Resilience Sustainability Facility. International Development Association Funding from the World Bank is also set to support a sustainability-linked bond to be issued in local currency.
Although conditions in the external debt market could eventually return to ‘normal’ for some frontier markets, reform remains essential for charting a sustainable course and attracting investment. Even then, securing alternative sources of finance – especially sustainability-linked finance – will be vital.
While the rewards for reforming countries are clear, we expect countries that do not conduct the necessary economic reforms will face an increasingly precarious outlook. If this current trajectory continues, we expect the future of funding in the frontier markets to look much greener.
