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Below is the list of countries held by the WisdomTree Emerging Markets Local Debt Fund (NYSEARCA:ELD) that I will be discussing in this article. The fund seeks returns of both capital and income appreciation by investing in local debt denominated in the currencies of emerging market countries. As you will see, most of the countries have great long-term prospects, but are suffering from short-term challenges.

As I mentioned in last week’s article, long-term positives are the low debt-to-GDP ratios and the high foreign exchange reserves these countries enjoy, and the fact that the dollar is expected to decline relative to their currencies once the global economy stabilizes. Even the Congressional Budget Office indicated in its economic and budget forecast that it expects the value of the dollar to decline steadily over the next 10 years.

This article will discuss the long-term prospects of the fund's top four holdings: Brazil, Indonesia, Mexico and Malaysia, and the short-term challenges that they face. Most of the challenges they face are inflation and declining currency values relative to the currencies of developed nations especially the US as the safety trade towards the dollar takes hold due to increasing global risk aversion. The countries are listed according to their portfolio weighting, from largest to smallest.

Country

GDP (Billions)

GDP growth rate

Debt-to-GDP ratio

Credit Rating

Brazil

$2,090.00

3.16%

66%

BBB

Indonesia

$706.70

6.50%

26.90%

BB+

Mexico

$1,039.00

4.50%

42.70%

BBB

Malaysia

$238.00

5.80%

54.20%

A-

Turkey

$741.90

8.80%

41.70%

BBB-

Thailand

$318.90

2.00%

44.10%

BBB+

South Korea

$1,007.00

3.40%

30.86%

A

South Africa

$357.30

3.00%

35.70%

BBB+

Russia

$1,465.00

4.80%

9.00%

BBB

Poland

$468.50

4.30%

55.00%

A-

Peru

$152.80

6.70%

24.30%

BBB

China

$5,878.00

9.10%

17.70%

AA-

Philippines

$188.70

3.40%

47.30%

BB

Chile

$203.30

4.80%

8.80%

A+

Colombia

$285.50

5.20%

36.50%

BBB-

Country

Cent. Bank Inflation Target

Inflation rate (most recent)

Inflation Rate 2010

inflation rate 2009

Brazil

4.5% (+/-2%)

6.70%

5.00%

4.90%

Indonesia

4-6%

4.42%

5.10%

4.80%

Mexico

3.00%

3.20%

4.20%

5.30%

Malaysia

2.5-3.5% (implicit)

3.40%

1.70%

0.60%

Turkey

5.00%

7.66%

8.60%

6.30%

Thailand

0.5-3%

4.20%

3.30%

-0.90%

South Korea

2-4%

3.90%

3.00%

2.80%

South Africa

3-6%

6.00%

4.10%

7.20%

Russia

7.00%

7.20%

6.90%

11.70%

Poland

2.5% (+/-1.5%)

4.30%

2.60%

3.50%

Peru

1-3%

3.98%

1.50%

2.90%

China

4.00%

5.50%

3.20%

-0.70%

Philippines

4% (+/-1%)

5.20%

3.80%

4.20%

Chile

3% (+/-1%)

3.70%

1.40%

1.50%

Colombia

2-4%

3.73%

2.30%

4.20%

Brazil: Brazil’s economy is in good shape from a long-term perspective. Its growth rate is expected to be above 3% for the coming two years, it has a moderate low debt-to-GDP ratio of 66%; it has a growing middle class; is self-sufficient in energy and a net exporter of raw materials.

Short-term however, Brazil faces many headwinds. Its currency has fallen more than 18% against the dollar since the end of July. With rising imports—up about 14.6% year-over-year—it adds to inflation and it also hurts company revenues.

For example, Petrobras’s (NYSE:PBR) profits slid 26% over last year due to the fall of the Real even while oil prices are at record highs. To combat inflation, Brazil raised interest rates and cut government spending; this affected the country’s growth rate, which fell by more than half from last year’s growth of 7%. The weakness in the economy prompted the central bank to start cutting interest rates. With high inflation, uncertain economic growth, bearish expectations of its currency due to rate cuts and the safe trade towards the dollar, Brazil will be a drag to ELD in the coming months.

Indonesia: Indonesia’s financials are sound. It has a very low debt-to-GDP ratio of 26.90% and $113B of foreign exchange reserves, equal to 16% of GDP. It has a high growth rate of above 6%. Its reliance on exports has been reduced and its domestic market has expanded, being one of the main engines of its growth. Unlike other emerging markets, domestic consumption makes up 70% of Indonesia’s growth. This freedom from reliance on exports and the other factors mentioned above makes Indonesia’s long-term outlook favorable.

Like others though, it faces short-term challenges. Indonesia needs to make some structural changes to insure its high growth rate is sustained. Manufacturing makes up a quarter of its GDP, and weakness in that sector suggests lower growth rates in the future. Investors in the sector are complaining about the levels of bureaucracy and high electricity costs. Its labor-intensive industries are facing competition from Chinese imports, raising employment concerns. A decline in raw material exports due to weak demand and a hurdle of bureaucracy and corruption are depriving the mining sector from crucial investments.

The country hopes that its ban of raw materials exports in 2014 will help spur investment in the sector by increasing incentives to build processing plants. Some believe that this move will increase costs to miners, leaving only mine projects with high rates of return operational.

Some positive notes are the increasing growth in its trade and retail sector. Indonesia has affectively reduced its reliance on exports for growth, a positive for its currency. Indonesia has a huge domestic market, which is attracting a high rate of foreign direct investment; it reached US $10B during the first six months of 2011, a 40% increase from the same period last year. Inflation is easing, allowing the central bank to cut interest rates to further help grow the economy, it is expected to grow by 6.7% next year. Another factor that will help growth is the fact that major infrastructure projects are due to be rolled out in 2012.

Indonesia has a bearish short-term outlook. The crisis in Europe is driving up demand for U.S. dollars causing a drop in the rupiah’s value. This raises costs of imports, and costs of foreign direct investment. The recent interest rate cuts adds fuel to the fire, raising concerns for inflation and further reduction of foreign investment. To ease concerns, the central bank has been actively engaged in the foreign exchange markets to prop up its currency and the government has made plans to increase capital spending. Indonesia is well equipped to weather this storm, and the weakness it is facing currently will provide for a great buying opportunity, in the meantime it will be a drag to ELD's performance.

Mexico: Mexico has done a good job in maintaining growth despite its drug war problems. Its GDP is growing at a rate of 4.5%, it has a moderate ratio of debt-to-GDP standing at 42.70%, foreign exchange reserves of around $130B, roughly 13% of GDP and a $73 billion contingent credit line with the IMF. These factors make it a strong candidate for long-term success, however Mexico’s prosperity is closely tied with that of the US. Eighty percent of its exports are destined there so in the end, its growth story hinges on America’s prospects. It is important to note that Mexico’s domestic services sector is rising at a rapid rate because of a rising middle class and high levels of government spending, giving it the ability to diversify away from its ties to the US economy, albeit at a small level.

Short-term challenges are tougher for Mexico because it is in a midst of a presidential election, during which time investment generally slows. Its currency is the most traded among the emerging market economies, making it more susceptible to global economic problems. As a result its currency has strongly depreciated against the dollar—about 18% from July’s high—forcing the central bank to announce two days ago that it will begin selling dollars to support the peso on days it depreciates by at least 2%. This is a positive, nevertheless it will not prevent the peso from falling further raising concerns for pass-through inflation. These factors make it difficult for the central bank to support GDP growth by cutting interest rates. Due to these facts I have a negative short-term view on Mexico’s local currency denominated bonds.

Malaysia: Malaysia has taken steps to become a high income-status country by 2020 by implementing the Economic Transformation Program that aims to achieve economic growth by attracting foreign direct investments. Malaysia's efforts have been successful so far. It reported a high growth rate of 5.80% recently, driven mainly by private investments.

Growth may slow down to about five percent however, as the affects of the European crisis spreads. If not, then Malaysia will be able to sustain its growth because it is not as reliant on exports to Europe as other nations are. The central bank has done a good job in controlling inflation. It has been steady at around 3% for the past six months. Because of that, the central bank decided to keep interest rates unchanged in November.

Bright spots of the economy are its manufacturing, services and agricultural sectors, which have grown 7 percent, 5.1 percent and 8.2 percent respectively. They have been propelled by strong domestic demand that rose 9 percent because of high rates of government and private sector spending. Overall Malaysia’s economy has not been hit that hard from the global crisis, inflation is expected to remain moderate throughout next year and growth is expected to continue to be strong. Its currency has fallen against the dollar, but not as much as much as the other emerging market countries'. Malaysia has the least drag on ELD’s performance, but if uncertainty about the global economy rises, Malaysia will follow the downtrend with its peers.

On a side note, Malaysia has a high rate of capital flight. Global Financial Integrity estimates that illicit flows of capital between 2000 and 2008 were $291 Billion. Major contributing factors for this phenomenon are government corruption and mistreatment of Malaysian minorities. These factors of capital flight and corruption are one of the reasons the country's debt level has risen to more than half of GDP. Some argue that the debt levels are not an issue because Malaysia has rising foreign reserves, which as of October 31st were quoted at about $135 billion, roughly 57% of GDP. Regardless of the reserves, if these trends of corruption, minority mistreatment and high government deficit spending continue, Malaysia’s long-term prospects will be in jeopardy.

Yesterday's announcment by the central banks to pump dollars into the system is very beneficial for ELD because the move devalues the dollar and gives investors some assurance that policy makers will take action if the need arises. This slighlty increases appetite for risk. Not all is well yet however, markets will still be volatile. Any dips that arise should be treated as buying opportunities.

Source: WisdomTree Local Debt ETF And Emerging Markets' Bearish Short-Term Outlook