Joseph Mariathasan: Should investors revisit local-currency EMD?
Joseph Mariathasan weighs the pros and cons of local-currency emerging market debt
Argentina just undertook its first international bond issue since its 2002 default, raising $16.5bn (€14.7bn) in an auction four times oversubscribed. As there is clearly demand for all types of emerging market debt (EMD), perhaps the time has come to revisit local-currency EMD.
Emerging market local-currency debt is a large and rapidly growing asset class. It is very liquid and available to any investor, so it cannot be ignored. But it has not been giving decent returns since the 2013 ‘taper tantrum’. Not surprisingly then, investors are reluctant to consider it seriously.
But with the asset class, it is important to separate out the structural long-term opportunities from the shorter-term cyclical headwinds we have been experiencing. The longer-term opportunities are tremendous, with local-currency debt now a $6trn market, accounting for 20% of the global bond markets, while emerging markets account for 40% of global growth.
Hard-currency EMD, by contrast, is a declining asset class primarily because emerging countries have developed the institutional infrastructure to be able to issue in local currency across the maturity spectrum. That structural change makes emerging markets very different in character today from what they were a decade or two ago.
The reason EMD has not been more prominent is the political risk associated with emerging markets. The volatility of the institutional framework of emerging markets compared with those of the developed world and the propensity for the frameworks of those institutions to change gives rise to the risk a country sets on a cycle that can lead to questions over its debt sustainability. Pension funds may also face reputational risk if they invest in a country that then hits the news as a result of political instability – Russia is a case in point.
But some of this may be misconceived. The economist Jerome Booth believes the market pricing of sovereign risk can be thought of as having three component layers. The first is quantitative based on macroeconomic ratios such as debt/GDP, fiscal deficits, etc. This garnered much attention during the euro-zone crisis with the work of economists Reinhart and Rogoff (2009) on sustainable levels of debt/GDP.
Second, Booth sees a policy layer, reflecting the ability of policymakers to implement sound economic policy, engender the spread of a market economy and for policy to react in an intelligent and timely manner to events. This depends on the development of a robust institutional framework incorporating independent central banks, savings intermediaries such as pension funds and insurance companies, and a regulatory framework that seeks to enforce a level playing field through the rule of law.
The third layer consists of just perceptions of risk, which Booth describes as the “prejudice layer”. The most significant development across emerging markets as a whole and in Asia in particular has been the phenomenal institutionalisation of their economies dramatically improving the ability of policymakers to implement policies. “In the 1997 Asian crisis, it was locals who fled the markets first, selling local assets and the currency to shift to safer havens,” he writes. “There is central bank independence now, a growth of domestic pension funds and institutional investors mandated to invest in domestic assets.”
But political risk also creates opportunities for active bond managers. The standard JP Morgan benchmark index suffers from the requirement to include only countries that have easily accessible bond markets. That means the index is essentially weighted towards 12 countries and lacks exposure to major Asian issuers such as Korea and India. But active managers are able to provide the full armoury of derivatives to generate proxy exposures to the bond markets. What that means is that investors should not regard benchmark indices as the minimum risk position for local currency EMD.
Perhaps the key issue for potential local currency EMD investors is not whether they should be investing but when. The danger for many investors is that of trying to time entry to hit the very bottom and, as a result, enter the market once it has bounced back some way. But that is human nature.
Joseph Mariathasan is a contributing editor at IPE