James Barrineau, senior vice-president, Alliance Capital
The opportunity in emerging market local currency debt has been much talked about as dollar debt spreads have shrunk. A less discussed aspect is the ramification of increased investor interest in this market for credit quality as a whole.
Increased investment in local currency instruments is helping feed a virtuous cycle of increasing dollar reserves and reduced currency volatility, which should ultimately result in a greater reliance by issuers on local debt as opposed to dollar debt.
This, in turn, should help reduce vulnerability to external shocks as countries shift their debt profiles into their own currencies with less reliance on dollar debt. Finally, a reduced supply of dollar debt in the medium term should keep dollar debt spreads well behaved as supply-demand fundamentals are even further improved.
While clearly not the only reason, this local currency preference has helped boost international reserves across the region, most notably in Brazil, Colombia, Mexico, and Argentina. These additional reserves are serving to underpin credit rating improvements.
Some countries, notably Colombia, are more aggressively deploying reserves to limit future issuance and to prepay multilateral debt. We think this is a wise use of resources in a world of high capital inflows and it serves to reduce downside risk should these inflows, as we have seen all too often, temporarily but suddenly decrease.
Stable to appreciating currencies also provide their own benefits. Generally, they should allow central banks greater flexibility in smoothing inflation and interest rate cycles. In the past, disorderly markets often accompanied higher interest rates as countries were seen to be slowing growth, and many times these rate hikes were responses to capital outflows that led to downward spirals. With more investors willing to accept currency exposure for greater returns, these stronger currencies can counteract some price rises and mitigate the length of interest rate tightening cycles.
Clearly there are risks, mostly centred on central bank performance. Central banks have to manage higher inflows and tend to the potential for growth spurts in monetary aggregates. The key is for them to communicate clearly to demonstrate a balance between growing reserves and combating inflation. Brazil has become a classic case where the central bank will have to articulate its expectations for inflation in the context of its desire to increase dollar reserve levels.
Jerome Booth, head of research, Ashmore Investment Management
Over the next few years, as institutional demand for emerging debt continues to grow strongly, the interest differential between dollar and local currency debt is set to reduce, thus increasing the attractiveness to governments of issuance in local currency. We have started to see Latin American issuance in local currencies in euro-clearable form, and this may experience expansion ahead.
Without diverting into an in-depth discussion on globalization, suffice it to say that an aspect of its nature is to speed up change and increase inter-connectedness. One response to this is to try and restrict the impact of globalization, reducing volatility, increasing the sense of (external) control. This is certainly a dominant policy response, across a whole range of policy, both in the G7 and developing countries. But it is not always successful and can lead to sudden change as control systems break down (i.e. a balance of payments crisis in the context of sovereign debt).
An alternative (though not entirely mutually exclusive) philosophy, however, is to foster the ability for government policy to react flexibly to the increased change that globalization brings. This option does not fit well with the control-obsessed, but the decentralization of decision making if possible can lead to greater stability, local ownership of policy and hence sustainability, and accountability.
Local currency debt issuance is standard for developed countries because we can trust developed governments to respect property rights. As creditworthiness improves in developing countries the same is true, and importantly there are real benefits for the government in having more policy options available to deal with problems as they arise – more flexibility. A government has much more control over debt in its own currency, and therefore fits into this category. The risks from external shocks are reduced and there are more policy options available to deal with balance of payments crises as they arise.
There are other benefits, also. In particular, the growth of a local currency debt market can assist the growth of domestic savings and development of the banking sector. It provides investment vehicles for local pension funds. As maturities are pushed out, it can foster both long-term finance for infrastructure projects, and also help stimulate the development of mortgage markets.
Under what circumstances should local currency debt be preferred to dollar debt? From the investor perspective, there are three main classes of institutional investors that have invested. First are those that already have some dollar debt and want a separate local currency debt mandate to add further diversification. Second are those that are more conservative, often coming from fixed-income perspective, and who are attracted to the better correlations, credit ratings and shorter duration. Third are those who wish to use local currency debt tactically within a dollar debt mandate. For the issuer, sequencing changes in the debt structure is not straightforward, and the key is the balance between the clear (long-term) benefits of issuing in one's own currency and the relative cost of doing so.
Raphael Kassin, emerging markets portfolio manager, ABN Amro Asset Management
The Latin American component of the emerging markets bond universe is where the excitement is, with high volatility and above average returns. The region has reached this stage partly due to conditions specific to Latin America and partly due to other regions developing at a faster pace and so, in a sense, it has 'dropped out' of investors' radar.
Other regions have also 'benefited' from special events, such as Europe's enlargement and Asia's huge liquidity flows, which have led to massive spread tightening and so diminished spread differentiation between countries. Latin America, however, provides a wide range of credit spreads and political/economic developments to keep investors constantly interested.
At the tight end of the credit spectrum, we find countries like Chile and Mexico. Both have implemented fundamental reforms and have been rewarded with investment-grade ratings, confirming their high level of fiscal stability. Of course, with low risk comes low yield. Panama and Peru have made efforts to follow Mexico and Chile's example and are en route to investment-grade ratings, though at a slower pace. Although different in terms of politics, economics and even social make-up, all four countries have followed the Washington Consensus.
Brazil has an economy as large as all the other Latin countries combined. The country has followed a more heterodox path as politicians have sought a more pragmatic and local approach to managing the economy. It is working. The country has developed substantially over the last decade. With today's market-focused economic team, a stable and fast growing economy, vast reserves of natural resources and growing integration with Europe and Asia, the sky is the limit. One can expect rating improvements there.
Venezuela comes immediately after Brazil in the credit ratings. Its economy is very different to most others in the region due to its huge oil reserves. There is evidence of fiscal restraint and a sturdy political will. The latter generally makes more newspaper headlines, yet the fiscal numbers together with a continuing strong oil market support the country's creditworthiness.
Argentina is a special case. The country has suffered dramatically recently but economic growth is picking up strongly again, and the results of the debt restructuring should provide a boost for it to follow some type of IMF programme and eventually return to the international capital markets. Of course, one must realize that the local view on how to manage the economy is far removed from that advocated by the Washington Consensus, but what matters in this case is that the local medicine is working.
Finally, Ecuador. While it is a country with a small economy, it is well supported by a diverse product base (oil, shrimps and bananas) and a forward-looking government (despite the occasional ups and downs). So, even if yields in the country's bonds are the highest in the region (11%), its economy is so diverse when compared to others that a true comparison proves a difficult task.