or the most bullish emerging market debt analysts, the rules of the game have changed: the traditional way of assessing risk and return in the asset class is no longer appropriate.
"There's been a paradigm shift since the 1990's and a lot of people still haven't caught on, says Dr. Jerome Booth, head of research at Ashmore Investment.
Even the more cautious players agree that a combination of cyclical and structural shifts since the late 1990's - changes in the investor base, global liquidity pools, developing world fiscal and financing policies, the increasing depth of local capital markets - should ensure that, in the medium term at the very least, EM debt will be a stable and growing asset class.
"Part of the problem is the term 'emerging markets'. People still associate it with huge risks. We should just call them 'non-G7 sovereign bonds' and move on," he adds.
Booth believes that a change in the investor base to pension funds and insurance companies has created a less volatile market with long-term commitments. In the 1990Õs more than a third of investment in EM debt was highly leveraged, leading to volatile flows and global contagion. The Asian and Russian crises forced them to move on. Concentrating on the day-to-day fluctuations on the EMBI has meant that many have missed the bigger picture, namely that emerging market debt is a risk-reducer for the new institutional investors across their portfolios.
ÒEM bonds are less, not more, volatile than global bonds,Ó says Booth. ÒSince 1998, people are realizing that this is a risk reduction asset class with double digit returns. ThatÕs why the past few years has seen a major reallocation to the asset class from long term investors.Ó
Booth downplays the emerging market debt sell-off on the back of increasingly hawkish G7 rhetoric on inflation at the end of October. ÒThe EMBI fell by 2%. ThatÕs hardly a correction. ItÕs a temporary pause while some short term factors play themselves out. TheyÕre not relevant to the institutional investor because this is a very good, long term market and there is huge demand on any dip,Ó he maintains.
Raphael Kassin, a fund manager at ABN Amro, agrees: ÒOctober is always volatile. People are closing positions and heading off on holiday.Ó
The Ôparadigm shiftÕ that Booth is suggesting is symptomatic of a more mature market learning lessons and adapting to new realities. ÒWeÕre seeing calmer behaviour. ArgentinaÕs default did not lead to contagion. I remember that only 30% of my clients even asked me about it. They knew that the important thing was the performance of the asset class as a whole,Ó he says.
As liberal capitalism embeds itself across the developing world, a significant growth market seems inevitable. Moreover, the increasing size and sophistication of local capital markets, and the number of local currency bonds, should diffuse risk through the system, reducing the impact of global shocks and the potential for contagion. ÒEmerging markets make up 85% of the worldÕs population. The facts of production in those countries lack cheap capital. In twenty years, emerging market bonds will make up one third of the global market. Right now theyÕre just 7%, but growing at 20% a year,Ó says Booth.
In the short term at least, this brand of optimism is shared by many. Kasper Bartholdy, head of fixed income research at Credit Suisse First Boston, predicts a gradual adjustment over the coming months in light of impending interest rate rises in the United States, Japan and Europe. But it wonÕt be ÒpainfulÓ.
Again, itÕs the economic fundamentals in EM countries that are cause for confidence. Bartholdy believes that most important change in the last eight years has been the almost universal adoption of floating or managed exchange rates. ÒNone of the higher risk countries (Brazil, Argentina and the Philippines) have fixed rates. In the past, sovereign defaults have arisen from central banks having to provide dollars to defend a currency. Therefore there is a consensus that the risk of default has fallen,Ó he says.
But, crucially, this has been accompanied by fiscal policies in key EMÕs that are straight out of the IMF prescription book Ð primarily, a commitment to ensure that the debt/GDP ratio is falling over time.
Arnab Das, Global head of Research at DrKW, agrees that currency management is playing a crucial role. Whereas EMÕs used to assert their credibility by pegging the currency, now itÕs being sought through fiscal conservatism, inflation targeting and current account surpluses, the latter acting as a Ôself-insurance policyÕ against economic shocks. This is true both in Asia and Latin America. ÒFor the first time in modern history, market conditions are tightening but EMÕs are not major borrowers. In fact, some are even creditors,Ó he says.
The EMÕs who are borrowing the most, and running the biggest imbalances, are currently the least vulnerable: central European countries locked into, and cushioned by, prospective EU membership.
EMÕs are thus well placed to adapt to the next stage of the global liquidity cycle. Das argues that there has been a shift from an externally financed stabilization boom (ie. sovereign and corporate bonds) to export-led growth. This shift was strongest in higher-beta, lower grade EM countries Ð those that had proven the most vulnerable to swings in global capital and trade flows, all a result of the cataclysmic political and policy changes arising from the currency and debt crises of the 1990Õs.Õ
But he cautions that separating the cyclical from the structural isnÕt always easy: ÒWeÕre not pure bulls; we acknowledge that positive EM ÔfundamentalsÕ owe in large part to the confluence of cheap money, high growth, and low inflation globally.Ó
Assessing the dangers that lie ahead, then, depends upon the extent to which you think this export-led growth is sustainable and what could derail it. Since no one is predicting a synchronized global economic slowdown in 2006, itÕs a safe bet that the outlook for EMÕs is good. As interest rates rise in the developed world, EM spreads will widen, but since new issuances will be thin on the ground, demand for the debt will tend to support prices across the board.
Michael Straughan, co-head of the Global Economics Unit at American Express, stresses that any widening has to be put in perspective: ÒSpreads in 2004 were 500 bps. At the moment weÕre forecasting 280bps over US treasuries if interest rates hit 4.8% in 12 months time.Ó He too is confident that EMÕs are simply less exposed to any downturn: ÒCompared to the 1980Õs and 1990Õs, countries in Latin America are not nearly as exposed on the external side due to structural policy decisions.Ó
Calm waters, then Ð but there are some economic forecasters, pleading the case for historical perspective, who see troublesome clouds on the horizon. As Ken Rogoff has cautioned: ÒWhile it is too soon in the current capital flow cycle to worry excessively about an immediate wave of major sovereign debt crisis, it is surprisingly easy to think of the five or six major reasons why problems could arise over the next few years.Ó
Structural policy changes in EMÕs may have changed the game, but those policies are in principle reversible. They have themselves been facilitated by exceptionally favourable global conditions Ð from low interest rates in the developed world to booming commodity prices. Moreover, global recession is still a risk, even if it might seem some way off. Likewise, the change in the investor base: that may well prove to be a long term shift that reduces volatility, but the balance could nevertheless alter. Speculators who got burned in the late 90Õs wonÕt stay away forever.
Finally, there will always be a risk of policy slippage in EMÕs as economic conditions worsen. In short, public debt could rise, reserves diminish (indeed, record oil prices are already taking their toll on Brazil et al), and G7 export demand fall. As long as these scenarios remain conceivable, the ÔcyclicalÕ components of the ÔstructuralÕ change will require constant vigilance.