Brazil s completion this month of a tender for $1.1bn of external sovereign debt, as well as Panamas call of all remaining Brady bonds, represents yet another milestone in debt reduction within the EM asset class. This follows similar debt buybacks earlier this year by Brazil, Colombia and Venezuela to the tune of some $30bn overall.
The generalized reduction in the stock of external sovereign debt is occurring at the same time as we are witnessing a significant reduction in primary issuance. Favorable global economic conditions have positively impacted many EM countries fiscal balances, reducing the need to borrow externally. In fact, there were no sovereign new issues in May (in contrast EM corporate new issuance in May totaled some $8bn more on that shortly), and for the remainder of the year expectations are for an additional $15bn of government debt.
With coupon and amortization payments of some $20bn expected for the remainder of 2006, repayment will very likely exceed new borrowings, thus resulting in additional debt stock reductions. The strength of this trend can be seen in Chart 1 which shows the gross external sovereign debt to GDP ratio for the three largest countries in the EMBIG index1.
The improvements in sovereign balance sheets and credit quality highlighted above have been widely acknowledged in the press and by financial markets. But they have also led many of our clients and consultants to ask us is this the end of the EM asset class?
For us the answer is a resounding no. Rather than the end, we view the current situation as an important transition as many EM economies mature and grow in global importance. It is critical not just to look at the debt side of the equation, but also at the size and growth of the real economies. According to the IMF, emerging economies account for 48% of global GDP (in PPP terms), and these economies are growing at an average rate of 7% versus 3% for the developed economies2. Thus their share of the global pie is large and growing.
For example, for the first time in 2005 the combined nominal GDP of the so called BRICs (Brazil, Russia, India and China) was larger than that of Japan, the second largest economy in the world, and the BRICs are growing at an average nominal growth rate of over 10% versus 3% for Japan3. If those rates of growth continue, then Chinas nominal GDP will be larger than Japans within a decade (note it is already significantly larger in PPP terms).
With their economic importance increasing one would expect the fixed income markets to move at least roughly in line with economic activity. That is, increased economic activity should go hand in hand with a broadening and deepening of fixed income markets, and investments in these countries would be expected to be an important component of any global fixed income allocation.
But at present these countries are significantly under-represented in relation to their economic importance. Chart 2 shows the IMF estimates for share of global GDP compared with those countries representation in the Lehman Global Aggregate index (as a proxy for fixed income investors exposure). Amazingly 96% of investments are concentrated in countries that make up only 52% of world GDP and the slower growing countries to boot!
Rather than the end of the asset class, the small allocations to EM countries in the Lehman Global Aggregate index suggest we are closer to the beginning. At PIMCO, we think that the next phase of EM investment opportunities will fall mainly in two areas, namely corporate and local market investments.
As shown in the chart below, for the first time in 2005, EM corporate issuance exceeded sovereign issuance, and expectations are for a continuation of the trend in 2006. So far this year EM corporates have issued $41bn of new debt, and expectations are for total corporate issuance to be in the $65bn range4.
Many EM corporates are now better positioned to access global markets, after all, in many cases they are operating in countries and regions that have seen sharp improvements in economic conditions. Not surprising then that some of the worlds largest corporations fall within this group. Take for example Gazprom. The 51% state owned Russian company is the largest gas producer in the world, accounting for roughly 20% of world gas production. With a market capitalization of over $200bn, Gazprom is one of the largest companies in the world, and one of the most profitable. Or take America Movil, the wireless telecom company that spun off from Telmex in 2000 and is now the leading wireless company in Central and South America, which is one of the fastest growing regions for wireless subscriptions in the world. And while these market champions remain more the exception than the rule, they do highlight both the potential growth opportunities and the strong operating environments many EM corporates are facing.
In addition to the increased issuance of corporate debt, the rapidly growing domestic EM debt markets also mark a key evolution in the asset class. Stronger domestic conditions in many cases as a result of a virtuous cycle of stronger banking systems, growing domestic savings, and reduced volatility have allowed many EM sovereigns to move away from the original sin5 of borrowing in an external currency while generating local currency denominated resources to repay the debt.
In Mexico for example the government for the past few years has been able to fully finance itself domestically and has only accessed the external markets to roll over existing debt (and opportunistically to further reduce the stock of external debt through various liability management operations). An important development in this regard was the creation of a mandatory private pension system in 1997, which with currently over $50bn in assets is an important pool of domestic savings that is invested in Peso denominated government bonds.
International investors are also taking an interest in various EM local markets for several reasons. Improving credit conditions and growing economic importance provide a strong fundamental foundation. From a valuation perspective, in many countries real rates and term premiums remain high due to risks associated with less proven central banks, barriers to entry (complexities in registration, taxation, settlement, etc), and potential volatility in less deep and mature markets. Investors have also recognized the diversification benefit that these markets provide when combined with other more traditional asset classes. At PIMCO we have seen strong interest in these strategies from our clients, and our investments in local markets have increased from $3.3bn a year ago to roughly $8.2bn today.6
So where does this leave us? The EM asset class is undergoing an important structural change, namely an expansion of corporate financing and a migration from external to domestic financing. At present, these markets are still in the early phase of their development, and periodic volatility and sharp corrections can be expected. But over the long run, it is very likely that investors will want to migrate more of their allocations away from the shrinking G-3 economies and towards many of these EM countries and companies.
Executive Vice President
1 Brazil, Mexico, and Russia make up 47% of the EMBIG index. Net debt is actually negative given large fx reserve positions across the three countries.
2 Source 2006 IMF World Economic Outlook
3 International Strategy & Investment 2/28/06
4 JPMorgan Emerging Markets Outlook and Strategy June 2006
5 Eichengreen, Hausmann, and Panizza (2003), The Mystery of the Original Sin
6 As of 5/31/0