Emerging market debt. Quite recently the idea seemed to involve quite a bit of risk. After all, investing in debt or fixed income investments are supposed to be conservative investments without either the risk or the volatility of equities. Emerging markets are supposed to involve a great deal of volatility, currency, and political risk. How could they become so respectable? One word: Greece.
In contrast to Greece, the balance sheets of many emerging markets look quite strong. While both Italy and Japan have debt to GDP ratios above 100%, almost 200% in the case of Japan, the debt of Brazil, Turkey, Mexico, Poland and even South Africa are below 50%. Tony Crescenzi of PIMCO put it very simply, “investors are asking themselves, ‘Would I rather lend money to nations whose debt burden is worsening, or to nations where it is improving?’ ”
Not only are the balances sheets often stronger, the yields are as well. For ten year bonds the bid price for Mexico is 3.95%, for Brazil it is 4.19%. Ten year bonds in the US are yielding only 2.43% and Japan’s ten year JGB yield only .62%.
But what are the risks? First is there is the currency risk. In the past unstable emerging market economies produced high inflation and volatile currencies. Often they would borrow in dollars, which caused a crisis if their currencies fell. Today the situation may be reversed. The credit ratings of many emerging markets are good enough to allow them to borrow in their own currencies.
The currency risks have also changed. Much has been written about the undervalued renminbi, it is not alone. The Economist’s most recent Big Mac index, a measure of currency valuations according to purchasing power parity, showed that several emerging markets including Mexico and Indonesia have substantially undervalued currencies. So if anything there is the potential for currency appreciation.
Inflation has always been a headache for emerging markets. Governments would often follow unsustainable development and social programs financed by international borrowing and printing money. Again it appears that the situation is reversed, as central banks in developed countries follow extraordinary loose monetary policies to avoid a nasty recession. Emerging market central banks have looked positively responsible in contrast although inflation in China, Brazil and India are causing concern.
But there are other risks including trying to determine the risk. The Greek crisis was certainly exacerbated by dodgy accounting. According to Pierre Cailleteau of Moody’s, a rating agency, “the state of public-finance accounting is extremely rudimentary relative to private-sector accounting.” Greece is subject to EU rules, has a democratic government and a free press. Legal institutions that allow for access to accurate information simply do not exist in many emerging markets, so the optimistic numbers may only give the illusion of solvency. The reality may be quite different.
It is not only information about governments that creates risk in emerging markets. It is the governments themselves. In developed markets, according to a recent study, increased government interference in the economy resulted in less efficient use of resources. For each percentage-point increase in the share of GDP devoted to government spending, growth was reduced by 0.12-0.13% a year. Emerging markets like India, China and Russia are dominated by the government. In all of these countries the government sector is over 50% of the economy. So the present fiscal situation could change rapidly.
In fact it is already changing. Due to the demand emerging market corporate and sovereign bonds have been issued at a record pace. They are 10% above 2009, itself a record year. This new debt may cause problems because of the nature of debt itself.
In game theory a debtor’s best move is to not pay back the creditor. Debtors do so for only two reasons: the law and reputation. An enforced law can require a debtor to repay. Without law creditors must rely on reputation. If a debtor gets a bad reputation then they cannot borrow in the future.
The problem with sovereign debt is that governments make the law, so collecting from defaulters like Argentina has been exceptionally difficult. Usually some sort of structured settlement is necessary similar to what is taking place with Dubai World.
Private companies are worse. The quasi governmentally Guangdong International Trust and Investment Corp. (GITIC) in China returned probably less than 2% to its creditors. More recently the creditors of Asia Aluminum also in China may have to wait a long time to see anything. Despite these risks, emerging market corporate borrowing now makes up about three-quarters of emerging market bond issuance, up from just over half before the financial crisis. Ominously the issuers are led by Chinese companies.
Investors want a return on their investments, but it is more important that they get their investments returned. At this point in the business cycle emerging market debt looks very attractive, but the lesson of the recent crash is that no investment is free from risk.
Disclosure: No positions