The local value in emerging market debt
When the subject of emerging markets comes up, people normally assume one is talking about emerging market equities (EME). Yet emerging market debt (EMD) is such a different category that it might have emerged from a different universe.
In the past two years, various sovereigns have been reaping the sweet rewards of declining interest rate differentials with the developed world, thanks to their efforts to catch up in a political and economic sense. Privatisations, movements towards liberalisation of trade and pension reforms are all part of the same trend. These countries are therefore likely to show, and have indeed been showing, above-average growth and productivity gains, thereby improving their credit fundamentals.
International investors are more familiar with accessing exposure to these developments by investing in emerging market debt denominated in hard currency. This is generally well-documented and therefore not the central focus of this article.
Increasingly, emerging market countries are trying to develop their local capital markets, to reduce exposure to exchange rate movements when borrowing in hard currencies. This also increases the borrowing possibilities for local companies. In addition, local insurance companies and pension funds that are gaining importance need to hedge their liabilities by investing in local currency-denominated instruments. Obvious examples can be found especially in Latin America (such as Chile, Argentina and Mexico) and in Central Europe (Hungary, Slovakia and Poland).
These are the causes of the differing dynamism in these markets when compared to international markets and indeed EMD. While international liquidity and risk aversion preferences can make interest in EMD quite volatile, the rationale for investing locally can be more robust. This should translate into different risk return characteristics and correlation patterns with other asset classes. One can argue that countries that maintain the reform path will witness productivity increases which will be reflected in the currencies outperforming their respective forwards. This provides another way of participating in the productive potential of these countries through the local markets.
The index which comes closest to measuring world-wide local currency performance is the ELMI+, developed by JP Morgan. Its biggest drawback is that it only relates to very short-term interest exposure in various local markets (six to seven weeks). Searching for indices that fully capture the domestic capital market opportunities in emerging markets, one is faced with only very partial indices, like Merrill Lynch’s or JP Morgan’s Central European government bond indices, which typically cover only Poland, Hungary and the Czech Republic. Bearing this caveat in mind, in Table 1 we show a correlation matrix of the EMD product in local (LC) and hard currency (HC).
A few things stand out. Judging the two asset classes as a whole, it becomes clear that the overall risk of the LC product is much lower than HC. While HC assets of different countries tend to move in tandem, the various LC assets vary greatly between countries, producing a more stable risk profile. On the other hand, the returns of the HC product have been far more appealing. In the same context, the EME performance has been disappointing, especially when the high risk profile is taken into account. The LC index also shows a lower correlation with high yield in comparison to its HC equivalent.
In general, the low or negative correlation of emerging market assets with US Treasuries and global bonds stands out, making this an attractive diversification in a fixed income environment. Economically, this phenomenon can be explained by taking two years as an example. In 1998, when the Russian crisis (and to a lesser extent the Asian crisis) hit emerging market equity and debt, the Fed lowered rates dramatically, leading to strong bond performance in developed markets. Conversely, in 1999 world economic growth picked up strongly, aiding commodities (especially oil) and leading to low or negative returns in global bonds. EMD (HC) saw tremendous spread contraction on improving fundamentals and EMD (LC) currency appreciation and lower yields.
Given that emerging markets are prone to event risk, one might wonder whether the LC asset class is as well behaved as it appears at first sight in times of stress. To understand this aspect more fully, we defined a subset of periods within which certain currencies were extremely volatile, namely the Asian, Indonesian, Mexican, Russian and Brazilian crises (see Table 2). Within each period, we looked at the correlation of those currencies with the others within the same region and with those currencies outside the region. While correlations typically increased within the region, the extent remained rather limited (in italics); also, the increase in correlations with currencies outside the region was very limited if visible. This contrasts with the riskier HC asset class, where correlations across countries are typically very high, also outside the typical times of stress.
This analysis made us more comfortable with the asset class as such. At the same time, diversification over the various regions remains important because it provides an obvious shield to these type of events.
Looking at the ELMI+ index, one should carefully examine the currency risks involved. These are manifold. On the one hand, there are freely floating currencies represented in the benchmark; on the other hand, quite a few are more or less tightly linked to the main currencies, notably the US dollar and to a lesser extent the euro. The direct influence of the US dollar on the benchmark is sizeable and larger than the impact of the euro. According to one’s view or hedging policies, one can hedge out this (implicit) dollar or euro risk.
To measure this influence we can look at the explicit links between currencies. Regarding the dollar-linked currencies, the Hong Kong dollar and Argentine peso and to a lesser extent the Singapore dollar and Turkish lira are worth mentioning. Making a checklist of all these types of institutional arrangements in the index countries, it becomes clear that at least 25% is more or less directly linked US-dollar risk and about 9% linked euro risk. Yen risk is of limited importance in the same institutional sense.
One can also take the empirical viewpoint. If a regression analysis shows that certain currencies are dependent on the US dollar, euro or yen one can analyse the implicit under- and overweight exposure of these currencies in the portfolio and take appropriate action.
The results of such an empirical analysis is shown in Table 3. The yen and Deutschmark show significant but low impact on the overall index changes (a). On the European sub-index level however, the effect of Deutschmark changes is sizeable and significant (yen inclusion does not seem to have much impact) (b). On the Asian sub-index level, the effect of the yen is significant although its explanatory power is limited (c).
On the Latin American sub-index level the relationships are quite weak, suggesting limited dependence on the euro and yen zone. T-values are low and the regression displays low explanatory power. Of course, one can do a similar analysis on a country-by-country level as well.
When actively managing a LC portfolio, one can thus differentiate one’s view on the various currencies from the currency it is pegged or linked to. Comparing one’s portfolio with the benchmark, one can hedge out the implicit euro or US dollar risk involved in the relative position versus the benchmark or alternatively hedge out all (implicit) US dollar or euro risk involved. For example, with central Europe being an overweight in our portfolios to gain on the convergence theme, we need to hedge out the implicit overweight that derives from these positions with respect to the euro in the case that we would like to be neutral on the euro versus the US dollar.
We feel that local markets justify an approach for its own sake. Many EMD asset managers allow local instruments to a limited extent in their hard currency products and approach the assets only from a very opportunistic basis. While the speed and promise of reform and capital markets varies widely from country to country and justifies hugely different allocations to the various countries involved, opportunities tend to be available most of the time.
At the moment, the convergence theme in central Europe is very powerful, pushing yields down; this theme however could also be applied with some limitations to the Mexican capital market, where a yield curve is being developed. Also, after many years, Brazil is gearing up to open its capital account, undoubtedly a precursor to deepening liquidity and developing a yield curve. In Asia, the Korean capital market will be open to foreign investment in the near future; after Japan, this is the largest capital market in the region in terms of capitalisation and should attract international attention.
To capitalise fully on these developments, we feel local presence is required. On the back of local and global mandates, we have built a multi-site team around the world, grouped per region; views on global liquidity preferences and the global interest rate outlook combined with international flows are typically provided top-down, whereas the local fund managers focus more on the local flavour (politics and the like) to provide bottom-up input.
Rob Drijkoningen is head of emerging markets debt at ING Investment Management in the Netherlands