A mass flight of foreigners holding local currency-denominated Latin American debt could trigger a fresh debt crisis in the region, a leading expert on capital flows to emerging markets has warned.
Carmen Reinhart, co-author with Kenneth Rogoff of last year’s ground-breaking study of global boom and bust cycles, This Time Is Different, said the surge in foreign participation in government bond markets had created an opaque but rising threat to domestic financial stability.
“I would be so provocative to say that these domestic debt burdens resemble characteristics of external debt since they are held by non-residents at high market rates,” Reinhart, a senior Fellow at the Peterson Institute for International Economics, told Emerging Markets.
The global market rally seen over the last 12 months has been accompanied by strong foreign appetite for local currency assets in emerging markets.
Foreigners currently hold some 29% and 12% of the outstanding government debt stock in Mexico and Brazil, respectively, attracted by relatively higher domestic interest rates, market depth and more manageable public debt burdens in these economies.
But Reinhart warned that investors, attracted to seemingly benign debt ratios in the region, should “remember that domestic debt liabilities are often not included in government debt statistics.
“In Brazil’s case, the central bank’s net foreign exchange position will be lower than its gross position [currently $356 billion] given its debt obligations,” she said.
Lack of market confidence in the sustainability of public finances has historically triggered macro-economic havoc in emerging markets when the bulk of debt was externally-issued.
Although the shift in local currency financing has helped to boost exchange rate and monetary policy stability – while lowering corporate funding costs – foreigners should not be complacent about the region’s rising debt burdens in gross terms, she said.
South American commodity exporters have issued a volley of domestic bonds in recent years, in part to cushion the inflationary impact of their governments’ interventions in foreign exchange markets aimed at weakening their exchange rates.
But Reinhart said a quick sell-off in domestic debt holdings would “really represent a claim against the [resident central bank’s] foreign exchange reserves”. This would highlight the large but currently understated volume of domestic liabilities particularly in Brazil, she said.
“We have seen strong foreign investor positioning in local currency debt markets this year despite the global economic risks,” Manik Narain, an emerging markets currency strategist at UBS, told Emerging Markets.
He said that rises in the dollar’s exchange rate or in US Treasury yields - as seen on Friday when 10-year yields hit five-month highs - were two factors that could dampen foreign appetite towards the asset class this year.
In March 2011 the value of domestic debt outstanding in emerging market economies had more than doubled since 2006 to $9.2 trillion, according to the Bank for International Settlements.
China, Brazil, South Korea, India and Mexico account for around three-quarters of overall supply of domestic debt – overwhelmingly comprised of sovereign notes - but strong capital controls inhibit market access for foreign investors in India and China.