Covid-19: Emerging markets will suffer the most

As liquidity issues mount in emerging markets as a result of the coronavirus pandemic, private capital needs to finally start making its mark, says Walid Cherif of BluePeak Private Capital.

Walid Cherif

We are certainly living in unprecedented times and more interestingly, the “we” means the entire globe. Nobody is immune. The covid-19 pandemic has shaken all societies, governments and economies, and clearly nobody can predict where or how this crisis will be resolved.

Health has proven to be the priority of all, rightly so, as it impacts human capital and labour markets. Facing a total and unprecedented freeze, the restrictions on movement have clearly impeded the functioning of almost all markets. The supply and demand function has been put under stringent testing and has been failing.

What does it mean for companies who employ people who were told by their governments to stay home? What does it mean for governments who, on the one hand, are restricting the movement of people out of cautious containment measures, and on the other, want to protect their economies and jobs? Economic fear is the new contagion and now seems to be spreading as fast as the virus itself.

Here, we analyse some of the early impacts caused by this pandemic and the economic responses announced by some governments.

Huge impact, early “global” response and a darker outlook

Ray Dalio of investment firm Bridgewater Associates estimates corporate losses to be in the vicinity of $12 trillion globally. If you assign a 60 percent share of those losses to emerging markets – equivalent to the share of EMs in the global GDP as of 2019 (OECD) – one can imagine the size of the hole the crisis will leave companies in.

Poor and middle-income countries will face tremendous challenges. The crisis has caused demand for the commodities on which many EMs depend upon to collapse. From crude oil to metals, from agricultural products to tourism, demand has simply vanished overnight. According to the Institute of International Finance, as of 10 March 2020, investors have pulled $83 billion from emerging markets since the start of the crisis. The MSCI Emerging Markets Index which ended 2019 up 18.4 percent has fallen by 30 percent so far due to the covid-19 sell-off.

The flight to safety and announced quantitative easing programmes remind us of the aftermath of the 2008-09 crisis and should increase liquidity in the developed world’s financial and money markets, making credit more available for borrowers. However, in EMs that much-needed liquidity will fund worsening budget deficits and will leave potential borrowers thirsty for much-needed financing.

Several governments in EMs imposed confinement on their populations, certainly the right thing to do in order to flatten the curve of contagion. However, it has choked economic activity in the process and the supply chain of goods and services has ground to a halt. Short of salaries, a large segment of these businesses in EMs will run out of cash to buy essential goods.

The question is how long this can be sustained? How can governments ensure the provision of the liquidity needed by private sector companies before it causes permanent structural damage? The lessons we learned from the 2008-09 crisis taught us that when credit intermediation is disrupted and capital stock doesn’t grow, recovery is slow, labour exits the workforce, skills are lost, and as a result, productivity goes down. The issue becomes structural.

Commercial banks are notorious for their risk aversion. Prior to the covid-19 pandemic, more than 50 percent of small and medium-sized enterprises in EMs did not have access to appropriate financing in their markets. I wonder what that number is today. While SMEs in Africa, as an example, are estimated to contribute to more than 60 percent of GDP, the finance gap is estimated at $431 billion for the 50+ million micro, small and medium-sized enterprises across the continent, according to IFC’s report on Micro, Small and Medium Enterprises published in 2017. That gap must be close to $1 trillion today.

“In EMs that much-needed liquidity will fund worsening budget deficits and will leave potential borrowers thirsty for much-needed financing”

The economic and financial responses to covid-19 have been loud and quick but without a doubt nationalistic. Each government, nation and country reacted to protect its borders and its local economy. Contrary to the values they hold, many countries such as those in the EU, are turning inward and are prohibiting the export of certain critical medical goods and in some cases food. This, however, is an exaggerated hysterical reaction.

To cite a few examples of government assistance in the developed world, the US has announced a $2.2 trillion rescue package (11 percent of GDP), France put in place more than $375 billion (14 percent of GDP) package in the form of credit guarantees to SMEs, tax breaks and employee benefits, and the UK has put forward more than $430 billion (16 percent of GDP) through a rescue package in the form of guarantees and direct cash payment to citizens. The IMF managing director, Kristalina Georgieva, said emerging market countries will need at least $2.5 trillion in financial resources to get through the crisis, and their own internal reserves and market borrowing capacity will fall short of meeting this need.

It is now clear that we have entered a recession as bad or worse than in 2009. The worst is yet to come for many emerging market countries, which Georgieva said have not yet been hit hard directly by the virus, but are suffering from capital outflows, reduced demand for their exports and a steep global drop in commodity prices. Asked whether the global economy needs more than the $5 trillion in new rescue spending pledged by G20 countries, Georgieva said: “Our advice is ‘go big’. This is a very big crisis and it’s not going to be sorted out without a very massive deployment of resources.”

In contrast, African countries’ responses have been small. To cite a few examples, Nigeria announced a $136 million programme (0.03 percent of GDP) and a reduction of interest rates on specific lending programmes, Kenya announced a few measures that aimed to increase liquidity in the banking sector including a reduction of 100 basis points of the overnight lending rate, a reduction of the reserve requirements and others. Tunisia announced a set of measures for a total of $850 million (2 percent of GDP) with the aim of supporting SMEs with short-term liquidity and a reduction of fiscal obligations as well as a 100bps reduction in the key money market rate. Clearly, the response is dismal compared to that of the developed world.

What EM companies need is not a policymaker’s symbolic reduction of the overnight rates or a delay in tax payments, they need meaningful capital that helps them to get back on their feet once the crisis is over. These companies need urgent liquidity, otherwise the risk of insolvency becomes imminent. Take a country like Tunisia, with GDP of around $42 billion (2019 estimate) and a private sector contribution of about 65 percent: one month of an economic shutdown will result in more than $2.2 billion of lost revenues for the entire private sector. If you assume just a 50 percent working capital need from that lost revenue, the liquidity needs would amount to more than $1 billion for one month.

If you extrapolate those numbers to the African continent, the immediate liquidity needed would be around $341 billion per month. Who will be providing that liquidity to these private sector companies? (These figures are for illustrative purposes only).

Solution = private capital (credit, mezzanine, equity)

Unlike the slow recovery from the 2008-09 global financial crisis, the IMF managing director said there could be a “sizable rebound” in 2021, “but only if we succeed with containing the virus everywhere and prevent liquidity problems from becoming a solvency issue”.

Post-covid-19 crisis, and as Africa’s economies recover and start to grow fast, the need for sophisticated and bespoke financing options is likely to increase. The penetration of private capital, in general, is low compared with that of more developed markets and many emerging markets.

According to a study by the World Bank, corporates in Africa have the lowest amount of bank debt when compared with corporates in other regions. Conservative African banks historically prioritised financing large corporates and government sponsored entities, while private African companies and especially SMEs and mid-cap companies face even more obstacles in accessing finance. The African lending interest rates offered by banks are higher than in many developed markets (14 percent and 8 percent in local currency, respectively, in Nigeria and Kenya against very low single-digits or zero in the developed economies). However, issues such as timing, bureaucracy, and the small size of many of these enterprises can complicate their ability to receive direct funding from multilaterals and international lenders.

“EM companies need … meaningful capital that helps them to get back on their feet once the crisis is over”

Pre-covid-19, there was already a substantial funding gap in Africa’s financing market. This crisis will only exacerbate the problem. I have always argued that part of the solution to the funding gap in EMs and in Africa specifically, was a vibrant alternative private capital market. Private equity, mezzanine, private debt and direct lending are just a few examples of what our markets need more than ever. That argument can only be made stronger after this global covid-19 crisis. Anecdotally, a colleague has shared with me a new concept she called EBITDAC – earnings before interest, tax, depreciation, amortisation and coronavirus. This concept really drives home the point. Whether you are in manufacturing, tourism, commodity trading, transportation or education, your earnings have substantially been slashed by the pandemic.

Today, policymakers need to focus on creating the suitable macroeconomic environment for the recovery to take place and should not be administering liquidity for private sector companies. That role should be left to financial intermediaries and asset managers. Governments should pump in liquidity and create rescue funds (credit, mezzanine, equity) to support SMEs but should not manage those funds.

Given the lack of financing alternatives for SMEs and mid-cap companies – including asset-light companies with solid business fundamentals, good potential for cashflow generation and promising growth prospects – investors like development finance institutions, pensions funds and sovereign wealth funds should be well positioned to benefit from the current situation and obtain attractive risk-adjusted returns both in the short and medium-term. In contrast to traditional asset-backed lending practices that prevailed in Africa, the opportunity lies in companies with strong fundamentals and growth characteristics, rather than relying solely on the availability and size of fixed assets to serve as collateral.

This crisis has created even more opportunities to invest in good and well-managed companies that simply suffer from temporary liquidity issues caused by the pandemic. Pre crisis, SMEs and mid-cap companies have had limited access to credit. According to the IFC in 2017, only 20 percent have debt on their balance sheet. It is time to increase that percentage through private capital solutions (mezzanine, private debt, direct lending, etc) and give businesses the resources they need to stay solvent and save jobs.

I believe EMs have a chance to respond strongly and find the resources needed to support SMEs. Those resources should be given to professional fund managers who understand the long-term prospects of those businesses that have suffered from the extreme impact of covid-19. Historically, private credit and private equity have been a very small asset class in Africa compared with other emerging markets, raising only $2 billion of capital for the continent during 2019 compared with more than $93 billion for the rest of the EMs. The time has come to change that.

Walid Cherif is the founder and managing director of BluePeak Private Capital (