IMF/World Bank 2007: Watching from the sidelines
Emerging markets held up relatively well during this summer's sell-off, proving to some that a true paradigm shift has occurred and economies are now better prepared to withstand external shocks. With the Fed’s aggressive 50bp cut in September, there is even talk of an EM bubble on the horizon. But not all countries are out of the woods yet, writes Paul Kilby reports.
In an ironic reversal of fortunes, the fault lines in the most recent market upset came from the United States, while the old troublemakers in emerging market countries essentially watched from the sidelines and waited to see if they would be hit by the fallout.
EM assets largely held their own, or at least saw investors distinguishing between credit risk, with Venezuela and Argentina taking a pounding on the back of weak economic policies and perhaps heavier positioning by more volatile hedge funds, while stronger credits like Brazil remained steady. Asia also largely seemed to be an island of tranquility with JPMorgan noting that “almost all [EM] countries remain unfazed by the recent turbulence”.
Even Turkey, whose external financing needs and current account deficit made it particularly vulnerable during these kinds of sell offs, stayed calm. “Nothing particularly disturbing happened in Turkey,” said Igor Arsenin, EM debt strategist at Credit Suisse. “The sell off in Turkey was relatively mild and the currency is stronger than it has been at the end June.”
As JPMorgan noted the EM correction was comparatively mild compared with other asset classes, and was driven more by gaps in liquidity than any fundamental repricing, For instance, the EMBIG widened by 66bp during the second half against a 159bp widening for US high yield, though the bank warned that more spread widening could be on the way given EM's increasingly stronger correlation with other markets.
On the other hand, Latin American equities did see some of its worst monthly declines in the past decade, which may have seemed odd given the strength of some of the economies and corporates. But UBS attributed the drop mostly to the abundance of foreign investors willing to head for the exits on any sign of weakness.
As far as emerging markets were concerned, the IMF looked sadly obsolete and seemed to be shouting in the dark when it offered help to EM countries when none was really required. Indeed, the lines between emerging and developed markets have been blurring as more and more EM sovereigns head toward investment-grade land.
“The fund stands ready to support any emerging market nations that are caught up in the market turbulence, although there have so been no request for assistance, and there has also been little pressure on exchange rates or reserves,” said then IMF managing director Rodrigo De Rato, in early September.
Thanks to lessons learned from the series of EM crises that roiled the markets during the 1990s, many developing countries have worked hard to reduce their vulnerability to external shocks and have given analysts good reason to think there is plenty of room for optimism.
In Latin America, for instance, enormous efforts have been made to develop local capital markets that can serve as an alternative to external financing, or wean the region from what former chief economist at the IDB Ricardo Hausmann referred to as the original sin of not being able to borrow abroad in domestic currencies.
Before the sell-off, EM sovereign and corporates had been able to entice yield-hungry foreign investors with cross-border local currency trades. And that market looked set to reopen in September as Colombian gas pipeline TGI retested investor appetite with an up to US$900m 144A Reg S offering which included a 20-year peso denominated tranche.
But perhaps more important is the growing strength of what is essentially a captive domestic investor base. Merrill Lynch estimates that local institutional investors in Latin America's principal markets will have about US$1.24trn under management and that figure is set to grow to close to US$2trn by 2011 or 56% of those countries' GDP. That compares to a relatively meagre US$356bn in 2002.
While these local markets have typically been the exclusive domain of high-grades corporates and the government, it is hoped that changing regulatory environments may open them up to a wider group of lower-grade borrowers. It was this burgeoning local market that was cited by Moody's in August as one of the reasons why the region's borrowers could withstand the drying up of international markets this summer.
At the same time, many emerging market countries have seen their fundamentals strengthen in the last few years, as commodity prices soared and the global economy boomed. With the exception of a few countries such as Venezuela, governments have largely maintained fiscal discipline and taken advantage of the boom years to improve their debt profiles.
Sovereigns have focused on liability management trades, mostly reducing dollar and other hard currency liabilities and shifting into local currency debt. Apart from the obvious advantages, the reduction in external debt also helped technicals, as demand overwhelmed supply.
"These countries are less dependant on external financing," said Credit Suisse's Arsenin. "Three or four years ago we would have been watching very closely how external debt was going to react to the financial meltdown. But surprisingly EM sovereign debt has held up well. It outperformed comparatively rated US corporates."
Over the last few years, EM assets have been buoyed by better fundamentals, a broader investor base focused on EM and perhaps most notably a tide of liquidity released after the US Fed and ECB cuts rates between 2001 and 2003.
And though rates climbed thereafter, a type of virtuous cycle had been put in motion. As HSBC described in a report earlier this year, EM central banks have been intervening to stop currency appreciation to help exports and hence accumulated massive dollar reserves, which they invest in turn in US assets.
This has kept a lid on US yields and perpetuated a higher bid for EM assets, HSBC argued, though it remains to be seen how or if EM sovereign funds will change their investment habits in the future.
Now with the Fed making an aggressive 50bp cut in both the fed funds and discount rates as it tries to contain the damage caused by this summer's sub-prime fallout and the corresponding credit crunch, some analysts are predicting an EM bubble is on the horizon.
Merrill Lynch forecasts an investment bubble in what it called the fundamentally strong emerging markets, arguing that the current situation is the reverse of 1998. That was the year after the Asian crisis and when the Russian default helped spark troubles at hedge fund Long-Term Capital Management.
This time the credit problem is centred on the US rather than EM, but the Merrill reasons that the extra liquidity intended to assuage sub-prime problems will be redirected to EM, just as the liquidity that was created to ease Asian, Russian and LTCM difficulties helped create the tech bubble.
"Every decade you have had an asset class that has gone from strong bull market to a bubble phase and that transition has been caused by central bank easing," said Michael Hartnett, global EM equity strategist at Merrill Lynch. "By trying to alleviate a credit crunch, liquidity injections have set off a euphoric phase for another asset class."
That bubble has not reached its zenith and Hartnett is saying that recent rate cuts may prove to be the last great buying opportunity in emerging market equities.
On the debt side, strategic and retail inflows for EM remain robust, standing at US$21bn or the equivalent amount seen this time last year, according to JPMorgan. And 61% of the EM investors questioned in the bank's most recent client survey said they plan to add risk, though 31% were still biased toward a reduction in risk.
EM risks certainly remain. Before the Fed decided on a 50bp cut in September, analysts were logically obsessed with EM countries' export exposure, particularly to the US whose economy looked likely to slow down, if not go into recession.
With 85% of its exports directed north of the border, Mexico seemed to be in a particularly precarious position, at least using these criteria. Israel is another vulnerable country with about 40% of exports sold in the US.
Other Latin American countries are less reliant on US imports, but a strong dependence on commodities would mean they would be particularly hard hit by a downturn in global growth.
For the short-term, however, most concerns emanate from EMEEA where several countries are suffering from fiscal and trade imbalances, not to mention a dependence on external funding. Hungary and Turkey are much cited examples, as is Kazakhstan, where there has been an abundance of bank issues into the international capital markets.
In its recent global financial stability report, the IMF also warns of rapid domestic credit growth "funded by foreign borrowing, mainly in emerging Europe and central Asia, which now absorbs nearly half of all international bank and bond financing”.
The Fund notes that international banks were unwilling to lend to such borrowers because of lack of transparency, but they have been able to tap international markets. That is likely to change.
Other possible EM trouble spots cited by the IMF, include what has been a growing private placement market in emerging Europe, the Middle East, Africa and to a lesser extend Asia. This market has sometimes allowed lesser credits, and first time issuers, to raise money without the extensive disclosure required in the public markets, raising the risks that trouble is brewing beneath.