Investors should consider emerging market debt (EMD) as a key component of a diversified portfolio. Despite various crises during the 1990s, EMD has outperformed versus all other asset classes over the last ten years (see Table 1). And, because the asset class is more closely aligned to other risk assets, such as high yield and equities, EMD is an important diversifier (see Table 2). In fact, historical data show that when markets are more volatile and unstable correlations turn negative between emerging markets and the government and high-grade fixed income sectors. As shown in Chart 1, had investors made a small allocation to EMD within a diversified portfolio between 1994 and 2004, the overall impact would have been to actually lower volatility.
Diversity and liquidity attract a stable investor base
With government yields in major developed markets trading at historic lows, institutional investors have been increasingly attracted to the risk-reward profile of EMD in recent years. A further fillip has been the growing maturity of the asset class. In 1998, the year of Russia’s default, more than 50% of countries in J.P. Morgan’s Emerging Market Bond Index Global (EMBIG) returned negatively. By contrast, following Argentina’s default in 2001, all countries within the same index returned positively in 2001 (except Argentina). The Argentine default in 2001 has been considered a watershed moment: the lack of contagion-effect on other emerging credits reassured investors that the asset class was more stable in the event of a country default. Institutional investor flows doubled between 2001 and 2004, and are estimated to total $10 billion for 2005.1 The effect has been to create a stable and broader investment base, thereby reducing the impact of volatile capital flows – a major contributor to the series of crises during the 1990s.
“Buy-and-hold” investors have helped to counter speculative trends, but the growing diversity and liquidity of the asset class has strengthened its ability to withstand exogenous shocks. An increase in the number of index constituents and a greater choice of benchmarks mean that investors can remain invested within the asset class, but at the same time exercise greater discrimination as to which markets they invest in. More liquid market conditions are helping to create more fluid supply-demand dynamics: trading volumes totalled less than $1 trillion dollars in 1992 and rose to $4.6 trillion in 2004.2
Better technical factors have been important in helping to reduce volatility levels since 1998 (see Chart 2). Nonetheless, the principal driver of EMD’s increasing stability has been the marked improvements to fundamental and credit quality trends. In 1993, the investment grade portion of J.P. Morgan’s EMBIG was 3%. This figure now stands at 43%, following Russia’s upgrade to investment grade status in January 2005 by S&P.3 Current trends also show that the number of emerging market upgrades exceeds the number of downgrades. Credit quality improvements have been reflected in the sharp decline in the yield spread of the asset class, which now sits at multi-year lows.
Lessons learned from previous crises
Several factors have contributed to the fundamental improvements of the asset class, but one of the most instrumental has been the move to floating exchange rates. Within the MSCI Emerging Markets Free Index, 87% of currencies float versus less than 5% over a decade ago. Initially, the implementation of fixed exchange rate regimes helped to end the period of hyperinflation that most economies suffered during the early 1990s. However, due to the impact of various external pressures, central banks eventually found the high currency levels imposed by the fixed regimes difficult to defend. A number of speculative attacks during the 1990s (on the Thai Baht, Russian Ruble or Brazilian Real - for example) exhausted the banks’ foreign exchange reserves. Inadequate reserves combined with poor fundamentals, in terms of large current account deficits and high public and private sector debt ratios, accentuated the problems for those countries operating fixed regimes, and left the artificially high currency levels unsustainable.
Forced devaluations created severe economic turmoil and disruption for a number of countries, and yet the longer-term impact has led to greater stability. Current account balances are much improved, with lower exchange rates and trade liberalisation policies attracting more foreign direct investment. A survey conducted by Credit Sights finds that the weighted average current account deficit among a selection of emerging countries was –2.1% of GDP in 1997; today, that sample’s average current account balance has moved into a surplus of 2.1% of GDP.4
With the help of rising commodity prices and increasing export levels, healthier current account positions have allowed for a faster accumulation of hard currency reserves (see Table 3). The Credit Sights survey finds that the weighted average emerging market credit in 1997 could only cover 5.2 months of imports out of reserves; today, reserves cover more than 7.6 months of imports. Much of this increase has been attributable to the surge in international reserves in the oil-exporting countries, with Russia the principle driver.5 In consequence, countries’ external debt profiles have improved, providing a major cushion to deal with potential issues, such as an external liquidity crunch.
Refinancing opportunities have also helped countries to improve their debt profiles and, at the same time, deepen local capital markets. Mexico, for example, reduced its external debt liabilities by $3.1 billion in 2003, and introduced a new 20-year fixed rate bond in October of that year; the latter drew broad interest from international investors.6 Brazil’s share of foreign-exchange-linked debt as a percentage of total domestic public sector debt fell from 34% in December 2002 to 9% at the end of 2004.7 During 2003, the Brazilian Government entered into a deliberate policy of reducing roll-over rates of short-term foreign-exchange linked debt and, in place, issuing nominal coupon fixed rate and inflation-indexed debt. As a result, the average maturity date of domestic debt has lengthened, while the market has broadened to incorporate more maturity sectors along the domestic yield curve.
The pursuit of constructive policy paths
Meanwhile, globalisation and convergence opportunities are setting sustainable macroeconomic frameworks at the nation state level, as well as fostering political stability. Eastern Europe’s active “accession path” to the European Union (EU) has been established under the Maastricht criteria, while Mexico and some Central American markets are moving closer to the United States under the guidelines established in the North American Free Trade Agreement. Turkey, for example, is now making significant efforts to reduce its fiscal deficit, given the long-term incentive of potential EU membership. Since 2001, government debt as a percentage of GDP has fallen from 112% to the current level of 77%.8 More generally, nation states are becoming more fiscally stable in the emerging regions: the percentage of government debt to GDP has fallen from 65.6% in 1998 to an estimated 50.6% in 2004.9
At the micro-level, reforms
to strengthen the underlying institutional framework and financial systems have been undertaken. After the Asian crisis, the authorities in Asia took extensive measures to improve supervisory and transparency arrangements, especially to stop the practice of unsustainable credit booms. Banks were restructured, insolvent institutions closed or put under government control, and non-performing loans reduced with the help of capital injection programmes. The International Monetary Fund (IMF) has also introduced programmes to improve expertise and oversight, and to raise early warning mechanisms of future potential issues. The IMF’s Financial Sector Assessment Programme (FSAP) has been established to provide technical assistance and advice, as well as to strengthen supervisory and reporting frameworks. Ongoing work is also being conducted into introducing global accountancy standards.
EMD within a diversified portfolio
A broader and more stable investor base, a more diverse and liquid market and significant credit quality improvements, owing to fundamental reforms, have contributed to the growing maturity of the EMD asset class. Although returns may moderate in the future versus historical data, there still remains considerable value within the asset class. Local debt markets continue to develop and expand, while other emerging markets still remain relatively untapped. The asset class represents 85% of the world’s population and a major source of potential growth, given the competitive advantages of lower labour costs and access to natural resources. As fears of volatile capital flows lessen compared to a decade ago, EMD is increasingly seen as a mainstream investment allocation; hence, it should not be overlooked during the portfolio construction process.
Mike Conelius CFA
The material is provided for informational purposes only and is not intended to be investment advice or a recommendation to take any particular investment action.
1 Jonathan Bayliss, JP Morgan and “Emerging Markets External Debt as an Asset Class”, Emerging Markets Research, JP Morgan Securities Inc.
2 J.P. Morgan
3 This number does not include those countries that have graduated out of the index such as South Korea.
4 Emerging Markets Strategy Overview – 1997 vs. 2004, Credit Sights, December 2004. A sample of 14 emerging countries were analysed, in terms of fundamental indicators, and weighted according to their composition of the index. The 14 countries comprise 89% of Merrill Lynch EM Index.
5 Emerging Markets Strategy Overview – 1997 vs. 2004, Credit Sights, December 2004
6 International Monetary Fund: Global Financial Stability Report, April 2004
7 Banco Central do Brasil
8 Consensus Economics Inc., February 2005.
9 Goldman Sachs: Global Economics Analyst, November/December 2004.