Emerging market local currency debt: Growth differential attracts long-term capital flows

Emerging market local currency-denominated debt (EMLCD) has been the last 'domino' to fall as the credit crisis spread outside the US, morphed into the crisis of financial intermediaries and presented serious challenges for the global economic outlook. This resilience stems from the same factors that are likely to support the asset class going forward. Emerging market countries are in much better shape now than they were a decade ago at the time of the last severe capital markets crisis. In fact, they are in a much healthier state than most developed economies. There are, of course, exceptions - Hungary with its large external financing needs, Korea with its aggressive recent build-up of corporate liabilities, or Argentina with its rapidly deteriorating institutional environment. Even so, these don’t negate the general improvement in sovereign fundamentals, policies and transparency seen in recent years.

Reason to be cheerful

For example, this time around, depreciation of the real actually reduces Brazil's net debt to GDP ratio (Brazil's public sector is a net external creditor), rather than posing a lethal threat to debt sustainability. While there are reasons to be concerned about the effect of lower oil prices on Mexico's finances, the country's balance sheet is in much better shape than it has been for a long time. Similarly, in Russia, the government has plenty of resources – as seen in its hefty foreign exchange reserves and the oil stabilisation fund - to implement a counter-cyclical policy and help out its over-indebted private sector. Meanwhile in Asia, Malaysia's competitiveness will enable it to keep on generating an impressive trade surplus even if the developed economies plunge into a synchronised recession. While the growth rate of emerging market economies is likely to slow, we still expect them to expand at much higher rates than their developed peers. This positive growth differential will continue to attract long-term capital flows to the emerging world, thus supporting currency valuations and helping to deepen local financial markets.

Unique appeal

In considering the outlook for EMLCD, it is also important to highlight some of the unique characteristics of the asset class. In an environment in which liquidity has deteriorated across the board for all asset classes, EMLCD continues to be supported by the structural bid from local investors, namely the pension plans and banks located in the emerging markets themselves. Indeed, in contrast to the more homogeneous sell-off in US dollar-denominated debt (which is ultimately a spread product), emerging market local currency bonds have reacted in very different ways to the intensifying global financial crisis: some have sold-off to allow for higher global risk premia, while others have rallied due to their status as the safest instruments denominated in their respective local currencies. Moreover, there is a big difference between emerging market government bonds (local as well as US dollar-denominated) and emerging market corporate issues, with the latter coming under much more significant pressure as global credit conditions tightened. With a few exceptions, Argentina for example, most current problems stem from the excesses of the corporate sector. In contrast, sovereign fundamentals are relatively healthy. We believe that in most emerging market countries, the moderating effect on domestic demand from slower global economic activity is likely to outweigh the inflationary pass-through from the recent currency weakness, thus creating ample room for local sovereign bond yields to compress.

Emerging markets are a very heterogeneous universe. The 'emerging market' label is a socio-economic classification, perhaps with a geographical overtone, and it is neither a credit rating nor a statement on valuation (such as 'high yield' bonds). As a group, countries represented in the EMLCD benchmarks are a very diversified bunch: some are commodity exporters (such as Chile and South Africa), while others import commodities (Hungary and Turkey). Some emerging market currencies are 'high carry', while others are not. Some are open economies potentially vulnerable to swings in global demand (Malaysia, Thailand), while others are fairly closed (Brazil, Colombia). In fact, most countries in the EMLCD benchmarks are rated solidly investment grade, so we should be very wary of generalising when talking about emerging markets.

The October 2008 spike in correlations of returns of various financial asset classes has diminished, rather than negated the diversification benefits of EMLCD. It is an asset class with two distinct sources of return, currency and local bond yields, representing some of the better rated countries in the emerging market universe and with the potential to generate equity-like levels of return without taking on, at least directly, the equity risk. As such, there continues to be a strong case for an allocation to EMLCD in a well-diversified portfolio.