THE GLOBAL financial crisis and the great recession that followed have exposed the developed world’s fragile public finances. Greece is almost certain to become the first advanced economy to default since Germany in 1948, while the world’s risk-free asset, US treasury bonds, could lose their AAA-status by the end of 2013.
Meanwhile, emerging markets have come of age, as improved fiscal positions and large foreign exchange reserves enable most economies to weather the worst financial crisis in 70 years relatively well.
This new-found resilience, alongside a favourable medium-term economic outlook, has been noted by investors, as has the relatively weak growth outlook in the developed world arising from the necessary deleveraging of public and private sector balance sheets.
Investors’ search for investments with sound fundamentals that offer yield pick-up means emerging market debt is likely to become an established asset class in years ahead. Following a series of self-inflicted crises during the 1980s and 1990s, macroeconomic policymaking in most emerging economies has evolved to reduce exposure to external shocks. Improved fiscal management in the build-up to the financial crisis contributed to a reduction in public debt-to-GDP ratios and the accumulation of large foreign exchange reserves, which enabled much of the developing world to engage in countercyclical policies through the downturn for the first time since the term emerging markets was coined by the International Finance Corporation in the early-1980s.
The improvement in public finances has seen government debt-to-GDP ratios drop below 40 per cent – a decline of almost 15 percentage points over the past decade – while primary surpluses are typically balanced or modestly positive, and interest rate expenditures have dropped from 4½ to 2½ per cent of GDP.
The dramatic turnaround in fiscal positions has increased creditworthiness among sovereign issuers and thus has been accompanied by significant upgrades from the rating agencies. Almost 60 per cent of the debt in the US dollar-denominated JP Morgan Emerging Market Bond Index is rated investment-grade today, up from less than 20 per cent a decade ago. Notable upgrades to investment-grade status in recent years include Mexico in 2002, Russia in 2005, Peru in 2008, Brazil in 2008, and Panama in 2010.
Sound fiscal management has been accompanied by favourable changes in monetary policy.
Through the 1990s, most emerging economies maintained some form of exchange rate peg, typically to the dollar, which compromised monetary policy independence. The pegs contributed to the overvaluation of emerging market currencies, as reflected in large current account deficits and vulnerability to a sudden reversal in capital flows as well as significant exchange rate risk, given currency mismatches on public and private sector balance sheets.
Most emerging market central banks no longer explicitly target exchange rates and typically attempt to achieve and sustain low inflation rates. The change in policy has contributed to lower inflation rates and greater economic stability.
The gains in inflation credibility alongside improved fiscal positions have helped to reduce emerging countries’ long-standing dependence on external finance. Traditionally, a lack of confidence among international investors meant emerging market sovereign issuers had to raise funds in “hard” currency, primarily the dollar, while the corporate sector typically had limited access to global capital markets and borrowed instead from banks. A change in investor perceptions, however, has contributed to dramatic growth in the size of local currency bond markets, which have increased sevenfold over the past decade versus a near-doubling of hard currency debt.
Access to local currency debt markets has opened not only to sovereign issuers, but also to the corporate sector. Sovereign financing needs have been light in recent years given balanced budgets or small deficits after interest costs and this, in conjunction with strong domestic demand given pension fund reform in some countries alongside a general distaste for equities in recent years, has allowed the corporate sector to fill the gap.
The associated reduction in currency mismatches only adds to the market’s attractions. The improvement in emerging market debt fundamentals has, not surprisingly, been accompanied by a structural rerating of valuations. The spread on dollar-denominated emerging market bonds versus US treasury bonds is close to 300 basis points compared to a historical average of 550 points, though well above the all-time low of 150 points registered in the summer of 2007. The decline in the incremental yield available on emerging market bonds has been correlated with the improvement in credit quality in recent years.
Like all risky assets, emerging market debt experienced a sharp sell-off during the fiscal crisis as spreads widened to more than 800 points, though the peak in spreads was roughly half that during the Mexican crisis in 1995 and the Russian default in 1998.
Investors are beginning to recognise the return potential on offer in emerging market bonds, and though cumulative inflows reached $76 billion in 2010 – roughly twice the highest amount recorded in previous years – asset allocations remain remarkably low at less than 1 per cent of total assets.
Any increase in foreign interest combined with already strong domestic demand could see spreads retest their all-time low, as the supply of assets struggles to keep pace. The time to increase long-term allocations is now.
charliefell.com
