Emerging market debt: Emerging market debt goes local
Building out term structures, liquidity and diversity in emerging market debt will improve the efficiency of both emerging economies and investors portfolios, write Peter Botoucharov and Edouard Stirling
Emerging and frontier market fixed income investing is entering a new phase of development. Returns are being driven by improving economic fundamentals and sourced from an expanding universe of investment opportunities. Today the asset class offers exceptional opportunities and growth in local market debt as opposed to foreign (hard) currency.
Total emerging market debt reached $9.2trn (€7trn) at the end of 2009, with local currency debt quadrupling to a dominant $7.8trn from $1.8trn in 2000 (see figure). Local currency debt now accounts for 85% of all total emerging market debt; the majority being presently issued by governments ($4.9bn). Institutional portfolios are yet to adjust to this change despite the fact that a few, more familiar, sovereign issuers explain the heavy concentration of debt - the BRIC economies comprise 70% of total emerging market domestic debt. Trading activity is also dominated by local market instruments, which represent 65-70% of the overall turnover in 2008 and 2009 according to the Emerging Markets Trading Association (EMTA).
Local currency debt markets can be observed across the range of the emerging markets. Benchmark transactions and extended yield curves are to be found across Brazil, Mexico, Russia, South Africa or Turkey, as well as in frontier markets such as the Dominican Republic, Serbia and Nigeria. In Sub-Saharan Africa, nine countries have active and functioning bond markets, with most having 10-year bonds and Nigeria and Kenya issuing 20 and 25-year instruments. While this growth is dispersed across continents, country ratings, size of economy and local government types, the trend seems firmly established as new countries seek to join the local currency debt club, policy makers seek to extend yield curves and investors seek diversification.
For sovereign issuers, local currency debt markets serve to increase efficiency in resource allocation, reduce external vulnerability, and create a transmission for monetary policy implementation. For global investors, local currency markets expand the investable universe, offer access to issuers with strong economic growth and improved fundamentals and diversifying risk. Growing local bond markets and deepening foreign exchange liquidity, continuous extension of yield curves, and improvement in the regulatory environment are all important drivers of expanding global investor demand.
Many economic factors justify the development of local debt markets. Among the macroeconomic justifications, countries with deeper domestic markets have a broader variety of policy instruments, which improve flexibility in both the formation of monetary policy and conduct of liquidity management. Currency mismatches also favour development of the local bond market as an instrument in the ‘de-dollarisation' or ‘de-euroisation' of the economy, as in Serbia. A larger and deeper local bond market reduces vulnerability to currency fluctuations and shocks, and hence to negative impacts on fiscal performance and debt indicators. Lastly, a local yield curve offers local institutions and corporates not only a better financing environment but also a broader risk management and hedging opportunity set of interest rate swaps and currency forwards.
Among the microeconomic justifications, the development of a yield curve in domestic currency anchors the costs of funding at different maturities for different issuers and creates conditions for more efficient allocation of resources. Extension of the yield curve also reduces the financing rates for the government and brings about one-off reductions in servicing costs. The local market becomes a stable source of funding for not only the sovereign but for the entire local financial and corporate sectors: over half of the $125bn local debt outstanding in Russia is debt of corporates and financial institutions, for example. Yield curve extension is also supported by local and international policy makers as an efficient means to access information on market expectations.
Local debt markets in emerging markets significantly expand the investable universe, and the majority of emerging market countries have ‘had a good crisis', and have continued to implement prudent macroeconomic policies, and improve the local regulatory environment and increase financial disclosure requirements towards international standards, so as to enhance financial sector stability in general. While progress has not been uniform, contagion from the crisis has been limited. That emerging and frontier markets have become the driver of global growth suggests that their economic fundamentals are increasingly solid.
With improving fundamentals the breadth and depth of investment opportunities will continue to grow. The size of total domestic debt has already grown significantly. It will continue to grow rapidly as new sovereign issuers enter the market and as more familiar sovereigns substitute foreign with domestic borrowing. The combination of strong economic growth and demand for capital is likely to provide global investors with higher returns.
Finally, liquidity will deepen, as both emerging and frontier market sovereign and corporate issuers tap their local markets, and the international investor universe for emerging debt broadens. Higher return potential allied to enhanced risk diversification will attract more investment from institutional investors.
The development of new markets offering enhanced returns and diversified risk will lay down a series of challenges for the investment community. At the most basic level, investors will need to look at how to adjust strategic asset allocation policies towards new opportunities which will be dynamic. There will also be challenges in benchmarking and performance measurement as new markets arise and older markets lose relevance, attraction and even liquidity.
Investment products and vehicles will need to expand or adjust to incorporate these new risk classes. Short term, investors will need to consider the difference between foreign currency and local currency debt products and how to manage credit and currency risk in both, while medium term, investors will need to consider opportunities in infrastructure, natural resources and developing industries as global growth balances shift.
Lastly, the institutional investment industry will need to review approaches in emerging and frontier markets in the light of best-practice habits established in developed regions. What governance procedures can be applied? How should best execution be sought, measured and delivered with which partners? Which policies to apply in securities lending and borrowing? How should allocations be adjusted - which transition management techniques to use and how fast? What types of currency hedging strategies make the most amount of sense?
The last few years have altered many investment certainties. Emerging and frontier debt markets are now visible as a robust part of our post-crisis landscape. The adjustments in long-term portfolios and investment techniques are just beginning as investors more broadly recognise and access higher yields embedded in the local currency emerging market assets, re-allocate towards the diversification offered in new regions and foreign exchange markets, and maximise their use of the local market expertise and risk management skills of partners that have developed in these markets.
Peter Botoucharov is director of quantitative research and strategy, and Edouard Stirling head of real money sales, at Standard Bank