How are emerging markets confronting El Niño and climate risks?

Nick: Welcome to ‘The Angle’ from T. Rowe Price ─ sharper insights on the forces shaping financial markets begin here. In this inaugural season of ‘The Angle’ we're diving into the world of the blue economy. I'm Nick Trueman and I’m your host as we learn more about this intriguing and rapidly evolving area of the economy and financial markets. In the series so far, we've had an introduction to the blue economy, learning about what it is and the threats and challenges it faces.

One current challenge is the return of El Nino, which is the focus of today's episode. Today, we'll be looking at how this weather phenomenon impacts water resources and more broadly, changing climate conditions in emerging markets. My guests today are Aaron Gifford and Willem Visser. Aaron is a sovereign research analyst and team leader in the fixed income team at T Rowe Price Associates. He makes regular visits to Latin America as part of his research, meeting policymakers, central bankers, and many others to see what's happening on the ground. Willem is an associate fixed income portfolio manager with a particular specialization in sustainable and impact investing. He has a wealth of investment experience and has undertaken several research projects looking at risks in and to emerging markets, such as permafrost melting and rising temperatures.

Welcome, Aaron and Willem, thanks for joining us today.

Aaron: Thanks Nick so much for having me on.

Willem: Thank you, Nick. Really looking forward to the discussions coming up.

Nick: Aaron, some of us have heard more about El Nino. Perhaps you can explain what it is and why, why we should all be interested in it.

Aaron: So really, in its most basic form, El Nino is a naturally occurring weather phenomenon where sea surface temperatures typically measure near the equator and the Pacific Ocean tend to be warmer than normal. It's part of what's called the Enzo cycle. Enzo standing for El Nino-Southern Oscillation. An El Nino typically occurs every 2 to 7 years and lasts for about a year or so on average. The cooler phase of the Enzo cycle is what's called La Nina. A bit of a fun fact. So, El Nino was originally discovered by Peruvian fishermen a couple of centuries ago. Back then, the fishermen would typically find every now and then that their catch was significantly diminished because of the warm water just off their shores, and particularly because they weren't able to receive that cold nutrients from deep in the sea.

They named the phenomenon El Nino, which in this case means Christ child, given the time of year that it typically appeared, which was around Christmas time.

Nick: Aaron, can you help us understand how it's impacting emerging markets? And what challenges does it pose for development?

Aaron: The reason El Nino is so important is that it disrupts ocean temperatures and weather patterns that can negatively impact everything from major fisheries off the coast of Peru, as I just mentioned, to crop yields in places like Asia and Africa, and to economic growth and inflation around the globe. And I would add, this time it's coming on the back of record temperatures worldwide, which is just, you know, magnifying the effect.

This El Nino has been less severe than what we've seen in previous large episodes, such as from 2014 to 2016, as well as the late nineties or early eighties. However, many organizations like the WMO, for example, still categorize the event as strong.

Just to give you a flavor of what we've seen so far from the current El Nino, I'd highlight that part of South America has seen torrential rainfall and flooding, while others have experienced drought. Some of the Andean countries, for example, declared a state of emergency last year due to the destruction that they experienced.

In parts of Asia - dry spells have also impacted crop production and even led to export restrictions of food staples in one of the largest economies in the region. There are a lot of moving parts, but I'm sure we'll dig into many of them during this podcast.

Nick: So, this really shows that the global impact you've talked about Latin America, you've talked about Southeast Asia. Perhaps one for Willem, so, what are the potential knock-on macro implications from extreme weather episodes?

Willem: Thank you, Nick. Actually, we're currently facing such a knock-on macro effect from the extreme weather, from actually an unexpected corner being the Panama Canal. So, in Panama, El Nino typically triggers dry spells and this caused this year insufficient rainfall. And this, combined with hotter than average temperatures, has led to a higher degree of evaporation of its lakes. And this in turn triggers lower water levels that flow into the Panama Canal. This canal we use for global trade. As a result, we've seen that the average number of daily ships passing through the canal have dropped from 37 to the mid-twenties. This is not only created long wait times, but according to Waypoint port services, passing slots or tickets to sail through the canal have gone up as high as $4 million per ticket versus $173,000 it was last year.

So, this really has a knock-on effect on inflation. We can see that the strongest El Nino’s tend to have coincided with higher than global average temperature changes. 2023 was the hottest year on record with temperatures 1.4 degrees above the pre-industrial average. El Nino is expected to remain strong and trigger more extreme weather events.

Nick: Willem, perhaps you can go into a bit more detail on what the impacts are, what are the things being observed?

Willem: The impact of these events become very visible through the disruption in agriculture and into the mining industry. If we look at the agriculture industry, dry spells can lead to bad harvests, lower crop yields. A reduction in crops pushes up prices with the biggest impact to those countries where food actually represents a large proportion of the CPI or inflation basket. And this especially happens in sub-Saharan African countries.

The world has already had to deal with plenty of inflation since the coronavirus pandemic, and El Nino can make it worse. At a minimum we've seen that several central banks, particularly in emerging markets, highlight the threat of El Nino for their inflation outlooks, meaning that interest rates could take longer to come down than what's justified by softening GDP growth.

Speaking about the mining industry, heavy rainfall and floods can also disrupt their supply chain. Any mine closures can lead to a high hit on growth in major producing countries such as Chile or Peru. And they can cause an increase in commodity prices with a knock-on effect that further tickles down the supply chain.

Nick: We've talked generally about where El Nino has its impact. And then we've had one specific example in Panama. But, Aaron, perhaps you could just dive into a little bit more detail on which countries are most exposed to El Nino.

Aaron: So, I would say Latin America is probably front and center when it comes to El Nino. You know, William did mention the likes of Panama. I would you know, include as well, the likes of Peru and Chile, both of which declared a state of emergency last year due to a localized El Nino event. Ecuador, for example, is also very vulnerable with some estimates of potential damages in a moderate to severe El Nino scenario totaling, you know, a few billion dollars. That's quite a bit considering the country's GDP is just north of 100 billion. And it also comes at a time when the country has had little room to maneuver, given its significant fiscal and debt issues.

Colombia, which shares a border with Ecuador and Peru, is also negatively exposed. But I'd highlight here that it tends to experience periods of drought instead of flooding during El Nino episodes. This is problematic for the country's agricultural and energy sectors, particularly hydroelectricity, which Colombia relies on for some two thirds of its energy needs. The current El Nino hasn't had the same kind of inflationary impact that Colombia experienced back during the 2014 and 2016 episode. But I would say that the risks are still front and center for the country's central bank that has already had to increase interest rates to historically high levels, you know, to fend off the existing pressures that they've already been facing.

Another part of the world that is particularly vulnerable to El Nino is the Indo-Pacific. In India, for example, an uneven and irregular monsoon season has caused inconsistent food supply, has pushed up inflation in key agricultural goods. It's also notable that the country decided late last year to ban exports of rice to protect domestic consumption. That has had negative knock-on effects for other countries in the region, such as the Philippines. Meanwhile, you've seen a prolonged dry season in places like Indonesia and even major forest fires in Australia. Nick: You mention Australia there, is there any distinction between how developed countries respond to El Nino effects?

Aaron: Now, I think it is important to highlight that the level of development of a country is directly related to its ability to withstand the effects of El Nino and climate change in general. So, while the developed world will be able to stand on its own two feet, at the end of the day, reality couldn't be any more different for, let's say, poor and low-income countries. Just looking at recent events in Somalia, for example, Ethiopia, we've seen hundreds of thousands of people that have been displaced by El Nino, even as those countries are already dealing with their own, you know, set of humanitarian crises such as hunger and disease.

So really, there are a confluence of factors, I would say, that need to be taken into account. But by and large, El Nino is a serious threat to many places and people in the world.

Nick: Well, we've heard that El Nino is associated with some real challenges, some negative impacts. But I understand that there are some potential benefactors from an El Nino phenomenon. Willem, perhaps that you can discuss some of the potential benefits or areas and parts of the world that do benefit in an El Nino year.

Willem: Absolutely. You touched upon an important point here, Nick. I think that's really important not to forget that there are countries that actually benefit from El Nino. These include countries that are susceptible to drought but experience greater periods of rainfall and are commodity producing countries. A great example in this case would be Argentina. Argentina just experienced historic drought and with the relief of the rainfall, which is obviously very welcome, has led to leading record soybean production. This is especially important given the challenging macroeconomic environment the country is facing, including depleted foreign currency reserves. Another example to think of is southern U.S. and northern Mexico. Both regions, again are susceptible to droughts, but El Nino brings increased rainfall, which does not only benefit the growing of limes, avocado crops in California, but also the rainfall triggers diminished tornado activity in the Midwest, sparing potential hits to GDP growth.

Similarly, in Mexico, plentiful rain reduced the number of hurricanes in the Gulf of Mexico, which brings stability to the offshore oil industry and boosts exports. Fewer hurricanes is also important for the small island nations of the Caribbean.

So maybe some anecdotal evidence of one my last trips to Chile late last year, I experienced firsthand that El Nino can bring unseasonably wet weather to the country. I know we cover this in another episode about water stress, but it's important to note that 23% of the Chilean installed power generating capacity is hydropower, and El Nino provides rain and snow, which keeps the reserves and water currents adequate for power generation.

So, this sector really benefits from a lot of rain and snow to the country. So, important to note that there are both potential winners and losers from El Nino. But in the wider context of climate change, almost all countries are likely to face challenges.

Nick: El Nino comes against the backdrop of rising temperatures due to climate change. How are emerging markets adapting to the challenges? Aaron, do you want to kick us off here?

Aaron: Yeah, sure. So, I would say that climate change is an ongoing struggle for many emerging markets. And, you know, as I mentioned before, the less developed the country, the more vulnerable it is to extreme weather events. The World Bank, for example, has highlighted that tens of millions of predominantly poor EM citizens could face extreme negative outcomes due to climate change.

And this includes food and water security and even forced displacement and mass migration. So, there's an ongoing global effort to deal with these issues, many of which have been highlighted during the recent COP 28 meetings held in Dubai, for example.

Nick: Aaron, you mentioned COP 28. For our listeners, perhaps you could just spend 30 seconds describing what COP 28 is.

Aaron: Yeah, absolutely. So, COP 28 was the 28th meeting in a series of meetings among global policymakers, the private sector, public sector, official sector. This one, in particular, was held in Dubai just recently. And you know, lots of things were discussed among, you know, many climate change and how emerging markets and low income countries are exposed, as we've been talking about on this podcast.

Nick: Thanks Aaron for that explanation, can you delve back into what developing countries can potentially do to help adapt to climate change?

Aaron: In terms of what developing nations can do to adapt to the effects of climate change, I think there are several options.

First and foremost, emergency preparedness is key, very powerful early warning systems have been developed, which governments should take full advantage of. I would also add upgrading poor infrastructure and addressing vulnerabilities in the agricultural, transportation, and energy sectors are also very important. This could include; anything from more sustainable irrigation practices, to using drought resistant crops, to implementing a more robust food storage, and distribution strategy.

On the energy side, the diversification of resources with a focus on renewable energy would also go a long way. Of course, the large majority of this requires financing, and as many of us know, emerging markets and especially low-income countries are ill prepared to foot the bill. This is why a coordinated global effort across the public, private and official sectors is so important.

We've already seen innovations in climate finance to channel resources toward mitigation adaptation strategies, whether, you know, through the public or even the private markets. Many programs for multilateral organizations are also in place to help countries in need, whether that's food assistance or special facilities to obtain emergency funds.

Nick: That's fascinating. Have you got any examples that you can share?

Aaron: I think one success story we should highlight in the context of climate change is once again Chile.

You know, this is a very diverse country with glaciers in the South and the vast Atacama Desert in the north. The country, for example, was one of the first ones globally to launch an ESG financing strategy with a variety of green, social, sustainable, and sustainability linked bonds. With those proceeds, you know, going toward everything from, lowering greenhouse gas emissions, to important projects in the transportation and energy sectors. On a very practical basis, you have even seen a shift in the government's approach to water stress with the development of several desalination plants to reduce the mining sectors reliance on fresh water.

This is an important advancement in a country that is frequently dealing with drought. There are several examples of countries making a successful effort in tackling climate change, and I think with the current El Nino phenomenon and record temperatures around the globe, those efforts will just continue to gather pace.

Nick: That brings an end to today's session. I want to thank Willem and Aaron for your input on the El Nino episode. Thank you very much.

Willem Absolutely. My pleasure.

Aaron: Thank you, Nick.

Nick: The key takeaway for me is that El Nino exacerbates already changing climate patterns, which poses risks for emerging markets and their water resources. There's a growing tension between human consumption in parts of the world where the population continues to grow and companies that also rely on water for many of their processes. Looking ahead to the rest of the season will feature a look at another emerging challenge facing the blue economy, which is water stress in Latin America.

Thank you for listening to the angle. We look forward to your company on future episodes in this season.

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