IFR: Back in Europe, why do you think the rouble market has been so disappointing?
David Smith: A lot of the sophisticated investors have access to local sovereign issues. Yes, you have to remove some of the restrictions, but invariably we are looking at Russia as an investment-grade credit and therefore you do not necessarily need to buy a Eurobond. But also, I do not think you have seen the same growth in the domestic investor base for external assets. I think people would rather buy domestic credits in the form of equity as opposed to the fixed-income assets. I definitely think Russia will grow, but for international investors, when people look at single-currency plays on the markets, if you are bullish in the asset class, you would rather be overweight Turkey than Russia, you would rather be overweight at 18% than at 6%. You are going to skew your asset allocation to those highest single-currency names. So Brazil is a positive for Latin America, Turkey for Europe and South Africa for Africa. In Asia it has been the Philippines and Indonesia.
IFR: Will it always be the investors who dictate which market is in vogue?
David Smith: The institutional bid for currency diversification is massive. There will always be appetite for Romania, Kazakhstan and Ukraine. I really do not think there is anything that an institutional investor will not buy into as far as currency diversification is concerned, provided the macro-economic picture is justified. But in terms of getting widespread investor participation in the market across the yield curve, you really need something else. Either you need a very strong FX appreciation story, a kicker in terms of high nominal yields or, most importantly, high real yields. But there are not many of those stories around. Turkey has its real rates are in excess of 8%, nominal rates have doubled to 18%, and you have great currency volatility. So if you back yourself in terms of timing, then you have transferred tremendous portfolio outperformance as opposed to buying markets like Czech koruna, where rates are euro rates and it is purely an FX play in a very tight training range.
IFR: A lot of Turkish lira issuance we have seen recently has been refinancing of existing bonds. Have we actually seen volumes increase that much?
David Smith: Yes, but we have also seen the first waves of redemption this year. A big redemption in February was fairly orderly, but issuance in Turkey has been running about US$5bn dollar equivalent for the last two years. Already this year in the first quarter we have seen in excess of US$2.5bn worth of Turkish lira issuance for Triple A issuers. Some of that is reinvestment, but there is still new money coming into asset class based on either interest rate or currency pullbacks.
Moti Jungreis: In some currencies you might have thought that people would say, "Look, give me my money back, I do not need to get involved right now", especially after the experience of last year. But people are still getting involved and still want to buy. So I would not ignore reinvestment: I think it is very important for this market and it is going to become an even bigger factor going forward.
IFR: So maintaining the same levels should be viewed as successful.
Moti Jungreis: Yes: it shows the market has developed and matured, and that people have an ongoing interest in it. It is not just a play.
IFR: How important is that from an issuer’s point of view? Does it demonstrate the sustainability you are looking for?
Michael Gower: I think it does. It is always very difficult to see what the actual reinvestment flows are. I think there is a lot more talk about reinvestment in US dollars and euros and larger-volume currencies, simply because coupon percentages and reinvestment on maturity percentages mean bigger volume. As the niche markets mature and volumes grow larger, it will become more significant. But while that cannot be ignored, new money into the asset class still seems to be the driver from what we see.
David Smith: And also the biggest drivers in Eastern European countries were the currencies that were pre-euro: so Greek drachma and Portugal were the drivers for the Czech Republic, Poland and Hungary. Each one of those was in succession and that has obviously driven issuance in markets like Romania or Slovakia, in terms of the second wave of accession countries.
But also you see asset reallocation from different markets. You may see some of the Scandinavian currencies still gaining from certain currency plays, but equally it might be Iceland or South African rand. Investors shift around all the time. You do see investors who will reinvest, but not necessarily always in the same currency. But they will be happy to have some element of currency diversification in their portfolios and will kind of pick and choose it as they fancy.
IFR: Is that why it is relatively easy for other banks who historically have not been involved in these markets to get involved now: because it is a movable feast, not one distinct animal, but always changing?
David Smith: On the surface, it looks like it is easier to get involved in those markets, but you have to realise that you cannot just pick and choose your markets. So you cannot just say, "We will just be involved in Turkey but we will not be involved in any other currency or asset class", because then investors will just assume you obviously are being opportunistic, you are focusing on one market and not supporting the whole asset class. I think that is fairly transparent. So you have to have a much more diversified approach and look at it as part of your whole business as opposed to thinking Turkey's a great market you need to be in because everybody else is making a ton of money in it. You have to realise that you need to be involved in emerging market local currencies either because it is part of your strategic mandate, because it is your niche business, or because you have always supported that investor base. Preferably, you can line up all three: then you have a successful business.
IFR: So you have to be committed across the board: you cannot pick and choose.
David Smith: Some people will obviously try to pick and choose. But for JPMorgan that is not the right strategy. Other houses might make short-term in-roads: it is always very easy to buy business or investor support, but I think eventually investors are aware of people who make strategic commitments to the market and are there in fair weather and foul, as opposed to those who are coming up with a particular product or a particular market for a short period of time.
IFR: And liquidity provision has to be across the board.
Moti Jungreis: You have to be committed. If you try to do back-to-back swaps, sell bonds and then move on, it does not work. There is an infrastructure element. You have to invest in systems that can swap and price those issues for you. You have to invest in people who are willing to commit to be market makers. And that is where the ongoing investment is done, you need to be committed. You cannot just hire one bond trader and think you are in the emerging markets: it does not work that way. Some institutions that made a short-lived commitment to the markets disappeared. What happens is that very quickly you see who is really coming into these markets and who is not.
Michael Gower: I think you can also see that fairly quickly from the borrower's side as well, because the type of information, the kind of dialogue you would hope to have with a bank as a borrower on these types of currencies is simply not feasible if they do not have the infrastructure, the trading, the sales, the visibility in terms of research on where the currency is going, what type of investors are going to be buying it, et cetera. If it is purely opportunistic, the follow-up is not going to be there, and from a borrowers' perspective, that is absolutely vital. It becomes evident fairly quickly if the substance is not behind the claim.
IFR: How long would it take to build up a sufficient track record to convince you?
Michael Gower: That is like the million-dollar question for a borrower!
IFR: How many banks do you typically have relationships with and would you talk to anybody who comes along with a proposal? Or do you regard a certain number of houses as being the core non-core underwriting banks?
Michael Gower: I think they are two separate questions. Do we have a number of houses we do non-core currency business with? Yes. If we look at 2005 and 2006, we traded with 54 counterparties. I would say four or five are our regular niche underwriters. That being said, the most important thing to us, in terms of selling transactions, is where is it going, and who the buyer is and why they are buying. I think, if party X comes to you and says, "We have a particular institutional investor who wants exposure in this particular currency and this is the price he is prepared to pay, we can swap you out", from a private placement perspective, we are always happy to do that. But from ongoing visibility and investment into these markets, there has to be some sort of demonstration of trading, liquidity provision, research and distribution capabilities in order for us to feel comfortable that there will be the bid/offer provided, that there will be an ongoing commitment to that type of market. Actually, a surprisingly small sector of the banking community has really said it wants to do that.
Petra Wehlert: I would say that we work with 10 to 15 banks in that sector, but at the end of the day there are three to five who really have a strong commitment in that market. And obviously we prefer to work with them, because then we can offer better products to investors. There are some other banks who claim to have expertise in different sectors, and, from time to time, if they have specific demand, you might do something with them. But it is not of the same quality that it would be with banks with a higher commitment.
So there are really only three to five banks, although others are pushing into that field. How successful they will be, it is hard for us to judge at the moment: perhaps we can judge it next year.
IFR: There may be other banks looking to get involved, but all the requisite commitment from trading through to research makes for a big financial investment. Is it worth it?
David Smith: If you are looking at portfolio inflows into emerging markets as an asset class, you have 2005 and 2006 running around US$10bn: 40% of that is going to local markets, so if you want to be a house involved in emerging markets, you have to trade in external debt and local markets. And if that is the growth area, you can only either add more currencies or more products, or hopefully you can try and combine the two and have a deeper penetration into the whole asset class.
Clearly, emerging markets as a mainline asset class, is growing. Everyone realises it is very important, and if you want to be a major player, you have to be involved in emerging markets. For many banks it is almost too important not to be involved.
Moti Jungreis: Clearly, I do not want to discourage any competition from coming in, but it is a limited market. People come and go and some will find their feet: if they are comfortable they will stay. But there is still limited scope there. You add up all the numbers of how much each bank involved is making, and you could not probably have 20 banks survive. So, unless the market really grows, that is where it is. Unless the market really grows and becomes as big as Australia and Canada, say, then probably the marginal guys who come in are going to find it really hard to be profitable. Then they are going to have to ask themselves fairly quickly whether they really want in or not.
And it is not a risk-free market. If you are a new entry to the market and you went through a sell-off in Turkey and Iceland, you may have been really good and made a lot of money, you may also have lost a lot of money, especially if you provided liquidity and you actively traded those markets. If you are a new entry to those markets and you lost a lot of money in Iceland, you have to ask if it is really for you: do you really have the stomach to go through that market and through the cycles again? If you made a lot of money, it would probably make you more aggressive and have more appetite to be involved. It can go either way. Sometimes it is just a judgment call on a trading desk that can create significant losses and profits. The franchise value of the markets is not so big right now that there is room for 20 banks to be involved. I think if there were, it will be very short lived, and many of them would exit.
Holger Kron: It is a question of cycles. As long as markets are shiny and nice, people come in and try, and some will be successful and grow and push further, and some will get hurt and disappear. We have seen it in Eastern Europe or even Scandies, where we have seen houses coming in, doing new bonds, trying to trade, and disappearing. And now you might find issues where the lead manager is not quoting a price because the desk that did this transaction has disappeared. After all, it is largely an economic function: you have to see what this business is and what it does for your institution. Although it is not purely about economics: it is about how things work together. It has to do with domestic markets and swap markets, how things can be used and put together. It is a game of Lego where you put things together and extract additional value out of resources you already have within an institution. You need the research, the capacity to do swaps, the credit lines: you need to be regarded as a top market player to find the swap and the credit exposure you need to do those bonds in the end.
As far as the newcomers are concerned, a few will stay and a lot will leave. Now we are experiencing shiny times, but when we see difficult times again, we will see that people cannot make the money they need to keep this sort of operation running.
IFR: So it is a self-assembly market, although usually with that kind of thing, you find there is one piece missing. Is that the case here?
Michael Gower: We should all be cognisant of the fact that it is a market that is driven by potential high P&L on the underwriter and swap side, and potentially very attractive arbitrage funding on the borrower's side. As these markets mature, the bid/offers obviously come in, and margins compress and issuance levels become less competitive. As borrowers, half of the reason why we are in these markets all the time is we do not want to miss the opportunity to get the best price out of a new market and the visibility that goes with it. From the banks’ perspective, I would imagine the attraction is getting that new currency and that big bid/offer for the first time and locking it in. But to get there you have to be established in these markets, otherwise you simply do not know where to look. If a bank we do very little with on the niche currency side comes to us and says they want to explore a new market, there is a natural scepticism from our point of view. We will point out that they have not really done that before and ask how they are going to manage the liquidity, where the swap is coming from, what is driving the exercise. There is an element of staying power needed that these three to five banks will reap the rewards from, and already have to certain extent.
IFR: So no room for newcomers, then?
David Smith: I think there is always room for newcomers, but I am also sure some of the old-timers will exit in time. Fundamentally, I think we ought to realise it is a bigger commitment than it would appear on paper, so to a certain extent you have to have luck in terms of timing. It is very easy if you have one trading loss but you have nine good years behind you: but equally, you do not want to be starting a new business and your first year is a loss. Like any business, you need a good start to make sure you can build a track record, or at least have a track record you can rely on when you hit the bad times.
Holger Kron: Another factor is the size of whoever comes in. The bigger you are, the more you can fertilise the little bits and pieces you already have within your organisation. There is a place for newcomers, but how many the market can feed is limited.
Moti Jungreis: JPMorgan and ABN AMRO are good examples. They are global players with a lot of branches and subs around the world that probably have some natural access to swaps in different places if they just look in-house. Those types of banks probably have room to be involved to a certain extent, and will probably do okay.
Petra Wehlert: It really depends on the overall development of the market. There is a lot of pressure globally to find new assets, and as this develops further, it is not only about swap markets, but also global demand. Then it may well be that the markets will be much broader and there is enough space for many banks. At the moment, it is still at an early stage, and there is a lot to work to do to reach that end. But we are open to suggestion: it is not that we do not welcome competition. Competition, in general, is a good thing. It is a good thing for investors; it is a good thing for borrowers. It is probably a harder thing for the underwriting banks, at the end of the day.