Foreign investors are angry at what they see as short-sighted and loose monetary policies in many emerging markets, despite a rally in emerging market bonds this week.
Driven by rebounding US equities and better-than-expected earning results from JP Morgan, the benchmark JP Morgan Emerging Markets Bond Index Plus tightened 24bp to 293bp above US Treasuries on Thursday.
However, analysts say monetary and fiscal authorities are not addressing inflation, which has hit double digits in many emerging countries, undermining any medium term exuberance for the asset class despite its strong fundamentals.
This has triggered investor flight into short-dated, hard currency bonds, curtailing the growth of local markets in the near term. Despite this week’s rebound, external bond spreads over the last month have widened in sympathy with global credit and equity market distress. But endogenous factors such as inflation and poor policy action are also weighing on investor sentiment towards EM fixed income assets.
"Many central banks, especially in Asia, are extraordinarily complacent when it comes to inflation," said Kieran Curtis, fund manager of around $750 million in two emerging market debt Sicavs for Morley, the fund management arm of UK-based pensions and insurance firm Aviva. "For external bonds, it is too early to say whether spreads have widened sufficiently. But the issue of the relative value of EM assets over US high yield is no longer the big one, it is inflation."
Local debt markets have also taken a hit. The JPM GBI-EM Global Diversified Index, the most comprehensive index tracking local currency bonds issued by emerging market governments, returned -1.3% in dollar terms during June. This is despite currency appreciation of 1.2% on average against falling bond performance of -2.5%.
Greater sophistication and independence of monetary policy as well as tighter fiscal policies have been cited as the key drivers for the impressive growth of emerging markets over the last 10 years. But in this period of acute global capital market distress, central banks are not living up to this recently established reputation, say analysts.
Excuses must stop
"Emerging central bank policies have by and large been way too short-sighted and it is time to stop making excuses and start aggressively hiking to prove their worth," said Brian Coulton, head of EMEA sovereign ratings and global economics at Fitch, arguing that rate hikes so far this year have been too little, too late.
With real interest rates in negative territory in many economies, central banks are far behind the inflationary curve amid strong political pressure not to aggressively raise borrowing costs in order to propel economic growth. Against the backdrop of a slowing global economy, the trade-off between inflation and growth has never been so stark.
Argentina, Indonesia, Turkey, Ukraine, Vietnam, Sri Lanka and India are just some of the countries where monetary policy has been criticized as being doveish, lacking institutional clout, and thus contributing to high inflation expectations. "The tighter central banks keep policy, the more reason you have to back them to preserve the real value of their currencies, which is what makes you want to buy local currency bonds," explained Curtis.
And so far, investors have been quick to savage dithering policy action. Turkey’s central bank credibility was brutally undermined in June when it was humiliatingly forced to slash its inflation targets for the next three years, sparking a widening of government bonds. Ukraine’s dangerously high year-on-year inflation rate of between 15-16%, as well as renewed fears of political policy paralysis, devastated the sovereign’s plan to launch a Eurobond early this month as investor demand quickly evaporated. While the continued controversy over official inflation statistics of 9.1% in Argentina against independent estimates of around 25% have pushed credit default swaps to an eye-opening 650-700bps.
Ominous Vietnam
But perhaps most ominously, Vietnam’s bond market came under threat of complete collapse last month when inflation hit a record 25%. The yield on the five-year benchmark government bond dipped under 7% in the first quarter and was little more than 9% in mid-April — yet at the end of June, the bond was quoted at 20%. A Morgan Stanley report in late May warned of the possibility of a currency crisis, comparing the situation to the 1997 Asian financial crisis. Despite the central bank hiking interest rates by 200bp in June to 14%, Vietnam’s example highlights fears over the direction and effectiveness of monetary powers across the region.
Fixed exchange rates have led to the historic undervaluation of many Asian currencies, but despite the clear benefits of using currency appreciation to fight inflation, policy-markets are not aggressively using this policy tool. This is because competition among regional exporters is arguably set to intensify over the next year as growth slows in destination economies in Europe and the US.
What’s more, Fitch’s Coulton attacks the consensus view among many monetary authorities that their policy tools are ultimately impotent to address exogenous commodity price shocks. In many countries, fiscal costs have shot up due to oil subsidies that are proving unsustainable. As a result, governments are being forced to cut fuel subsidies, "releasing pent-up inflation that has previously been repressed, with other second-round effects coming through, particularly wage pressures," according to Philip Poole, head of emerging market research at HSBC.
"These second-order effects mean that an inflation shock that was initially exogenous for many economies, the result of sharply higher hard and soft commodity prices, has become endogenous. This will make squeezing out inflation much more difficult with the risk of a wage price spiral."
Inflation then is set to be a stubborn medium-term threat to macroeconomic stability and investors are poised for a high interest rate environment and possible currency volatility in many emerging economies. As a result, investors are in retreat, strangling primary market liquidity and imposing high premiums for new issuers for investment grade companies, junk names and sovereigns alike.
Nevertheless, a research note by Investec Asset Management argued that the current spread widening for local emerging market debt presents a good buying opportunity since it is likely to outperform most other risky asset classes this year. "Combined with base effects reducing the inflationary impact from commodities, we think inflation will soon start to stabilize and later start to come down. Bond markets are likely to start discounting these developments in the near future," says Investec.
"Somewhat weaker growth will reduce the pace of currency appreciation in emerging markets but there will still be plenty of positive stories, particularly in those markets where a strong balance of payments underpins currency strength."
Grim outlook
However, Michael Ganske, head of emerging market research at Commerzbank, disagrees. He argues that in the near term the outlook for local market issuance looks grim as central banks finally tame the inflationary tiger through high policy rates. "This could bring the structural trend of moving out of hard currency into local markets bonds to a temporary halt," he says. "Sovereign issuers would increasingly be forced to shift their funding strategy back to global bonds, changing the market mechanics and as a result questioning the hypothesis of ‘Sovereign hard currency bonds as a dying asset class’."
For example, in June, the Philippines reneged on its ambition to curtail external borrowing and boost local debt issuance. The sovereign is currently mulling plans to launch a global bond in the next few months as liquidity in domestic markets has dried up.
Despite the political and economic risks of unstable price performance, analysts say some highly indebted nations have taken a benign view on inflation since price rises erode the real value of sovereign debt, boosting a government’s budget position. However, Curtis at Morley urged governments to resist these temptations. "In countries like Turkey where most debt is short dated and they have to roll it over every year and 18 months, trying to inflate debt away is not going to work as all you are doing is increasing your interest costs. You still have to repay the debt even if the nominal repayment is not so bad."