Emerging market financing today is very different from the 1990s. Public-sector funding is fast shifting from sovereign debt to local markets, and external funding to corporates/banks. Emerging markets (EM) asset markets are opening, deepening and broadening further than ever before. Macro investing is shifting from sovereign bonds into local markets. Credit, public and private equity, and privatization, green-field or cross-border M&A all play an increasing role in EM corporate finance. Portfolio investment in EM firms has spread from bonds and loans across the capital structure to subordinated debt, perpetuals, mezzanine financing, private and public equity, and local currency corporates.
Yet doubts persist about the viability of this portfolio shift in EM liabilities and G7 assets: Can this shift outlast the highly-supportive global cycle of recent years? Can EM fiscal and external surpluses survive the tightening of global monetary conditions? Will the pendulum swing back to sovereign debt, once again crowding out corporates and local markets?
These doubts are reasonable. Exceptions are glaring – particularly among new EU members or candidates, whose sizeable external and fiscal deficits are substantially financed with sovereign debt, raising sustainability concerns. Episodes like the Q2 volatility, driven by shifting US monetary conditions, hit local markets hard and curbed primary market access for lower-rated corporates. And structural reform is uneven at best. Finally, the Goldilocks cycle elevated commodity export prices and volumes and contained G7 inflation and interest rates, boosting portfolio flows and asset prices, so EM balance sheet improvements may prove cyclical, too.
Structural shifts
However, important long-term changes in economic policies across EM countries and their rising global economic weight suggest the portfolio shifts are structural:
Firstly, a shift from fixed FX rates to inflation targeting and (managed) floats is allowing for yield curve extension as central banks gain independence and credibility.
Many EM countries are thereby overcoming “original sin”, as economist Barry Eichengreen christened the source of inability to issue long-term debt at reasonable real-interest rates in domestic currency – expropriation of savings via default on government debt, whether actual or de facto by inflation. The process is incomplete.
Liabilities in many EM financial systems remain short, constraining investment in longer-dated assets. Market memories of political-economic instability prevent quick fixes. But privatizing pension systems will help by lengthening liabilities, improving asset-liability matching in duration space, to complement the FX matching of public debt and tax receipts reflected in the shift to local markets. EM countries not guilty of original sin with a sustained history of moderate rather than high inflation, like India and South Africa, have long been able to issue long-term domestic currency debt with little trouble. Others like Brazil, Mexico, Poland and Turkey are increasingly able to issue long-term, local currency debt.
Secondly, significant reductions in inflation and inflation expectations point to rising policy credibility. This process still has a long way to go, and will no doubt continue to be interrupted by external shocks that hit exchange rates and boost inflation. To entrench economic stability and to disassociate inflation from exchange rate shocks, central bank credibility must be beefed up. Ultimately, fiscal accounts must be strengthened, and current and contingent government liabilities reduced to levels that can be financed from taxes or domestic debt. Such reforms would curb short- and long-term inflation expectations, contain long-term real yields, and reduce the degree and speed with which exchange rate shocks affect inflation and expectations.
Thirdly, a sharp improvement in national balance sheets including reduced public and external debt is crowding investors into local markets and into corporates. Fiscal accounts have swung into primary surplus, and current accounts into overall surplus, thanks to export-led growth in many EM countries. As a result, sovereign debt is becoming an endangered species, if not extinct. The most remarkable case of this progress is Russia, which has managed to repay almost all its sovereign debt in just seven years since the blistering 1998 debt/currency crisis.
Fourthly, the G7 is structurally underweight in EM countries relative to their economic size and growth rate. So investors and corporates will very likely need to increase EM exposure over time. Several major EM economies are already nosing $1 trillion in nominal GDP, and are growing two to four times as fast as G7 economies. Today, EM countries contribute some 20-25% of annual global output at market exchange rates, closer to 40-50% on a purchasing power parity (PPP) basis. And, the PPP-basis GDPs of almost all EM countries exceeds nominal GDP – opposite to the G7, implying that over time, exchange rate evolution should boost EM GDP relative to the G7. Yet, G7 bond and debt indices carry EM index neutral weights well below 10%.
Major risks
Of course, important risks to all of these positive developments and prospects abound in the G7 and EM itself, relating to domestic policies and global conditions. EM economies are key beneficiaries of globalization. Should free trade and investment face a backlash in the G7, EM exports would be hit. And, with non-residents lining up to invest in EM countries, it is only a matter of time before current account deficits once again appear. Maintaining financial stability and open borders to trade and investment in the G7 and EM is therefore paramount.
However, there are fundamental reasons to think the excesses of the past can and will be avoided. The general reaction to political-economic turbulence following the external debt/currency crises of the 1990s was to strengthen macro policies and reform programmes. While there are notable exceptions, most EM countries continue to signal a broad-based commitment to low inflation and sustainable growth, and ongoing opening to global trade and investment.
Finally, possibilities for portfolio diversification and risk management are far greater than before, thanks to varied macro performance and advances in market microstructure, pointing to greater stability for the asset class as a whole. The shift from dollar pegs to managed floats and inflation targets points to differences in economic cycles. Macro imbalances are now prevalent mainly in the highest-rated EM countries.
Meanwhile, lower-rated countries with greater exposure to external shocks are husbanding surpluses. Thus, different countries will respond differently to external shocks. And risk management via derivatives like CDS, FX or equity futures and forwards, and currency or interest rate swaps, as well as by outright positioning in countries with different economic risks, can prevent the transmission of a shock in one country to all others, stabilizing individual portfolios.
The author is head of emerging market research at Dresdner Kleinwort