The Bank of International Settlements (BIS) has warned on the lack of transparency over foreign investment in emerging market local currency instruments in a report unveiled yesterday. A working group chaired by Banxico general director of operations David Margolin concluded that reported foreign holdings of emerging market local currency debt may substantially underestimate the actual picture.
“Discussions with private investors and authorities in some countries indicate that the underlying exposures of non-residents are in some cases, including Brazil and Korea, considerably larger than the data on outright holdings would suggest. This is mainly due to the use of derivatives, including offshore non-deliverable forwards, to gain synthetic exposure to local currency markets,” said Mr. Margolin.
Derivatives allow traders to replicate financial strategies originally conceived with financial assets without the need to directly trade the underlying assets (for more analysis on this issue, see "Savvy investors step up emerging market exposure"). The BIS also noted cases where resident financial firms (including foreign subsidiaries) are counted as final holders when in fact they are holding the debt on behalf of non-residents.
This could magnify the effects of global volatility on local markets, according to the BIS, as well as intensifying risks for local financial institutions.
“The use of derivatives may allow some foreign investors to build up complex and potentially highly leveraged positions that might be suddenly unwound in the event of market turbulence... Also, to the extent that foreign investors hedge their currency exposure from their local investments, local investors as a group will build short forex positions that could prove quite expensive in the event of market turbulence,” said Margolin.
Examples of the first problem were evident during the sell-off in Turkish assets in mid-2006, which the BIS research suggested was partly the result of “large reverse-knockout structures on the Turkish lira.” With regard to the second risk, the Russian banking system lost substantial money on hedging instruments sold to foreign investors before the collapse of the local bond market in 1998.
The BIS also considered the possibility that the “internationalization of local markets may increase correlations and the scope for volatility spillovers across countries’ local market returns,” but investors remained divided on this question. Helene Williamson, head of emerging markets debt for F&C Investments, recently told delegates at the Emerging Markets Traders’ Association forum that credit quality differentiation tended to disappear in sharp bull or bear markets.
Paul McNamara, local currency portfolio manager at Augustus Asset Management, agreed that there was a risk of herd movement among unsophisticated investors, but argued that the impact of this would be less than in previous years, thanks to the strength of emerging market sovereign balance sheets.
“Even in smart trades, if there is enough stupid money, you can still get hurt. But short-term sell-offs today won’t hurt fundamentals the way they did in Brazil in 2002,” said McNamara.
The BIS research supported this contention. In particular, Margolin believed emerging markets stand to benefit from deeper and more diverse derivative markets that allow a greater choice of instruments for risk management purposes, improving market efficiency. Moreover, volatile hedge fund activity in local markets is increasingly giving way to inflows from pension funds, usually intermediated by fund managers to tackle the complexity of tax, legal and custodial matters.
“The entrance of pension funds, which is viewed by observers as an ongoing multi-year process, offers the prospect of continued growth in non-resident allocations to local markets, given the funds’ low initial holdings of local currency assets in relation to their large total portfolios, and a potentially stable investor base, given the long-term investment horizon of this group of investors,” Margolin concluded.
Known as the central banks’ central bank, the BIS holds 6% of the world’s currency reserves, researches global finance, and provides central bank policymakers with a forum for discussion. Its research report entitled "Financial stability and local currency bond markets" is available by clicking here.