Analysis round-up
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Emerging Markets

Analysis round-up

Asia growth, Local currency debt, China bond market


- T. Rowe Price argues that the US consumer will no longer be the primary driver of global growth. Domestic demand is recovering in Europe, Japan and Asia (ex-Japan) and China will gradually become less an export economy but an importer fuelled by domestic demand contributing to the GDP. This latter development will help smaller regional players. “Over the longer-term, we are likely to see the trend of smaller Asian economies achieving higher economic growth rates as China and India’s growth rates plateau to more sustainable levels – a trend described by some commentators as “the passing of the baton.”


Given these developments, T. Rowe Price argues: “ a new set of opportunities is opening to global fixed income investors. In particular, longer-term Asian currency appreciation is expected as a result of the region’s structural economic improvements.... With yields rising in Europe and Japan and reaching a plateau in the US, there will be limited scope to take advantage of relative value opportunities between these major bond markets. The self-sustaining domestic recoveries in Europe and Japan should mean that interest rate differentials will continue to narrow between all three economies against the backdrop of growth moderating to trend in the US. The Federal Reserve is expected to leave interest rate policy on hold, while the ECB and the Bank of Japan should tighten interest rates further to renormalise their monetary policies. Investors must, therefore, look to the growth of local emerging debt markets for higher yield opportunities within the global fixed income universe.


Secondly, with developed sovereign bond markets offering limited value, investors can seek higher real yield opportunities in local emerging bond markets where interest rate cycles and inflation expectations are favourable: for example Brazil, Turkey and Mexico”.


- Jerome Booth of Ashmore Investment Management Limited cautions that local-currency denominated debt not only presents opportunities but significant challenges as well. “Local currency debt should not be managed as a money market fund with higher yield – looking to allocate relatively statically to countries. Active management is crucial to avoiding risks, not just adding alpha (countries do not default or devalue without having identifiable problems – managers who ignore this by not focusing on policy and political dynamics are the ones that get caught out)”.


Regulatory issues also presents potential problems: “Local currency debt instruments may be subject to local laws, counter-party risk, withholding taxes, and various discriminatory policies towards foreign investors, and may be complex to settle. Hence many fixed income managers have in the past instead favoured dollar-denominated Euro-clearable debt. This is now changing and there are also a few examples of local debt issued in Euro-clearable form under international law”.


Moreover, Booth argues that the safest exposure is through derivatives: “The most efficient, liquid and safest way to gain exposure to local currency debt is often through derivatives which have a yield component (i.e. not spot foreign exchange) such as currency forwards, non-deliverable forwards (NDFs) and interest rate swaps. These can be entered into with a range of top global investment banks, though care still needs to be taken over the legal detail of these contracts, requiring specialist legal expertise. Risk management systems also need to be focused on economic exposure through a derivative as opposed to just the cash exposure one would look at in the case of a bond. Hence our local currency debt portfolios often have around 50% cash whilst at the same time being considered fully invested from a risk point of view. To buy derivatives and then manage to cash levels is to create a highly geared product typically unsuitable for institutional investors”.


- Standard Chartered argue that China’s debt market is very small and its improvement should be a priority for the financial system. “Put aside official debt, and the market shrinks to a fraction of its former self. In addition, China's bond market is still illiquid and is being held back by poor regulatory co-ordination. This lack of bond market development is delaying important progress in other parts of the financial system, particularly interest rate reform.”


The reasons cited for China’s small illiquid bond market is: - split market - lack of variety of investors - PRC banks tend still do not like trading - This disposition to buy and hold (rather than trade) has been exacerbated by the recent rise in bank excess cash holdings - market making system on the IBM has not worked that well - the nascent quality of MoF benchmark issues - the lack of shorting.

 

They suggest the following measures: “A major overhaul of the regulatory framework - A government-sponsored pool of securities available for borrowing and shorting - More frequent, larger official benchmark issues - Fewer restrictions on issuers and investors”.

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