The uncertainties surrounding the timing of the Fed taper and the ill-advised fear of a revival of 1994 call for an update of the emerging market [EM] risk. One of the big differences between the mid-1990s and today is the asset and liability position of EM countries. Over the last decade, we have witnessed a dramatic shift in EM's balance sheet.
- The mid and late 1990s crises were partly attributable to a combination of currency mismatch (between the currency denomination of assets and liabilities) and original sin (the difficulty of borrowing abroad in their own currency). Any sharp increase in global risk aversion (VIX) and fall in global liquidity would trigger a huge sell-off and contagion among EM markets.
- Over the last decade, the world has witnessed a "role reversal" where inflows into EM local currency bonds have risen sharply. Not only have EM countries been able to reduce their dependence on foreign currency denominated bond financing but they also strengthen their self-insurance with the accumulation of foreign exchange reserves (mostly U.S. Treasuries).
This balance sheet reversal came along with new challenges for EM economies: as the risk switched from a balance of payment crisis to the management of foreign portfolios inflows and assets, they had to design new tools to gain credibility in macro management.
Unsurprisingly, EM local currency bond returns are highly dependent on idiosyncratic factors, not on global risk indicators. This is what the chart below highlights. It shows the relative sensitivities of local currency and USD-denominated sovereign bonds to U.S. Treasury yield (5-year) since 2010.(click to enlarge)
We see that:
- The sensitivity of local bonds is well below that of USD denominated bonds. In addition, for a wide range of countries (Eastern Europe, in particular), the sensitivity of local bonds is statistically insignificant.
- The countries most sensitive to a change in UST yields are in Latin America.
The charts below shows that the excess return of local currency to USD denominated bond is not correlated to the changes in the VIX (risk aversion) or UST 10-year yields.
The lesson to be drawn from those charts is that even if the tapering leads to a sharp increase in long-term rates, the impact on EM debt will not be straightforward, as local currency bonds seem to be partly immune to the U.S. Treasury yield risk.
But it's a little more complicated than that. Recent works by the Bank of International Settlements (BIS) show that local currency bond returns are unsurprisingly, more sensitive to idiosyncratic factors, such as short-term interest rates and fiscal policy. Even though some economists attribute the growing appetite for local currency bonds to the relative lack of safe-haven bonds (in the wake of the euro crisis, for instance), most of the capital inflows have been related to a better perception and a growing credibility of local macro management. In particular, without the constraints associated with currency mismatch and external debt management, EM policymakers have much more leeway to carry out domestically focused policies.
Yet, the growing uncertainty on China's growth model coupled with the difficulties that many emerging markets are facing in readjusting their policies have raised doubts on the sustainability of the growth regime of many EM countries: inflation, export dependence, etc.
Even though their work is based on sovereign CDS, Aizenman, Jinjarak and Park stress that "prior to the crisis, the markets placed greater importance on external factors, in particular trade openness. The global crisis and its aftermath brought to the fore the challenge of managing crisis. The markets thus gave a bigger weight to the scope for the government to use fiscal and monetary policy to mitigate the adverse impact of crisis. As a result, public debt/GDP ratio and inflation - indicators of fiscal and monetary space - became more important in explaining sovereign credit default risks."
I completely agree with this view, adding that over the last few months, many EM local markets have not suffered that much from external shocks (even though the fall in commodity prices has not helped) but from growing doubts on the ability of their policymakers to properly tackle the ongoing economic challenges.
Therefore, it is not so much the fear associated with a soft tapering off by the Fed that should trigger a sell-off in emerging markets, but rather the rapid worsening of their idiosyncratic situations.
This should be a cause for concern for investors exposed to EM bonds (both USD denominated but also in local currency). As the latter shares the same risk of carry trade strategies: capital and exchange rate loss in case of a sell-off (unless of course they are hedged, which is far from always being the case). This is clearly what the charts below show: the 1-month return differential between local currency bonds and U.S. Treasuries is highly correlated to the 1-month return in the associated FX pair.
To sum up: the sharp decline in the current account balances of many EM countries suggest that the idiosyncratic risk is growing. As a result, local currency bonds may be immune to the Fed taper, but remain highly exposed to the growing carry trade risk.