In recent weeks, battle-hardened emerging market analysts have been tempted to utter the fateful refrain: “this time it might be different”. Over the past month, the correlation between US treasuries and high-grade, hard-currency-denominated emerging market sovereign debt has jumped, indicating the latter's safe haven status within the emerging market asset class. Sovereign bonds, from such countries as Brazil, Colombia, Mexico and South Korea, tend to outperform their higher-beta sovereign counterparts in a risk-off environment. However, the very strength of emerging market sovereign debt as an asset class, on a cash bond and credit default swap basis, has ignited investor optimism.
“While some of the European sovereign debt markets have transformed from a rates market to a credit market, in the Asian market, in particular, the reverse trend is developing based on the relative strength of the region's macroeconomic fundamentals,” Neeraj Seth, head of Asian credit at US fund manager BlackRock, says.
Emerging market hard-currency bond funds have attracted about $18 billion in fresh capital so far this year, attracted to the diversification value of developing economies – and spreads. To wit, the risk premium on dollar-denominated emerging market sovereign debt remains at 370 basis points over US treasuries, according to the JP Morgan’s EMBIG index. Meanwhile, a clutch of eurozone sovereign debt markets and US corporate credits offer historically low, or negative, yields.
“The relative value of Asian high-grade and high-yield debt is attractive relative to their US equivalents, given the spreads on offer, growth prospects and the lower leverage of Asian corporates and sovereigns,” says BlackRock’s Seth.
In other words, even with the notable slowdown this year in the large emerging market economies, it’s back to the future. A liquidity-fuelled rally in high-rated emerging market sovereign debt is justified on the basis of stronger growth prospects in southeast Asia and South America, in particular, attractive returns and strengthening credit metrics relative to the developed world.
And yet, from 2007 to date, emerging market rallies have been blown off course thanks to global economic and market shocks. Against this backdrop, risks cloud the emerging market fixed-income outlook, analysts say: capital flows might destabilize domestic financial markets while the threat of outflows perennially looms given the risk-on/risk-off calculation of global investors, who are prone to home-bias during global shocks.
But what’s lost in this narrative on the cyclical volatility of the emerging fixed-income market amid a medium- to long-term structural bull run is arguably the biggest factor that is driving global capital flows in the current environment: the global shortage of perceived safe assets.
The improved risk perception towards emerging markets has coincided with shifting sands in the global financial industry. In short, a reduction in supply of perceived safe assets – US agency bonds and a lack of creditworthy sovereigns in the developed world, in particular – has been met with increased demand for collateral by banks and non-bank intermediaries given more-stringent regulatory requirements. As the IMF noted in a seminal Global Financial Stability Report in April: “Safe asset scarcity will increase the price of safety and compel investors to move down the safety scale as they scramble to obtain scarce assets. It could also lead to more short-term spikes in volatility, and shortages of liquid, stable collateral that acts as the ‘lubricant’ or substitute of trust in financial transactions.”
Collateral crunch
In other words, global financial markets are in dire need of high-quality collateral. These forces have created a role for emerging market bonds in the global pool of safe assets, says BlackRock’s Seth. “There is an expectation that high-rated emerging market bonds are on the path towards being seen as so-called safe assets for global markets.” In other words, fiscal prudence combined with greater sophistication and liquidity in domestic financial infrastructures will facilitate the usage of emerging market securities as safe assets domestically – and possibly in global markets, says Seth. For now, regulatory constraints – principally, liquidity and ratings requirements – substantially reduce the stock of emerging market assets that can be formally designated safe asset status for global financial intermediaries, analysts say.
But the biggest obstacle is not the demand for emerging market sovereign debt, globally speaking, it’s the lack of supply, say analysts. As the April IMF report noted, at the end of 2009 emerging markets accounted for approximately 40% of global GDP but their contribution to financial depth was less than 20 percentage points that of advanced economies. To make the point another way: EM economic expansion has outperformed capital market growth. Emerging markets’ share of global GDP rose substantially between 2002 and 2010 – from 20% to over 30% – while their share of global capital markets rose from 11% to just over 14%. What’s more Citi, citing IMF statistics, says that the structure of EM capital markets is bank-heavy: in 2009, EM bank assets made up 39% of total capital markets size.
A key driver for the modest size of the developing sovereign bond markets is the savings-investment surplus in China, with its local debt market off limits to foreigners. So when will emerging markets provide global markets with an investable pool of assets? David Lubin, chief economist at Citi, is not optimistic. He noted last year that “a rising supply of assets in nominal terms doesn’t necessarily produce a rising level of financial depth. Having said that, it does seem likely that GDP growth will, over time, result in financial deepening. The problem is that financial deepening doesn’t necessarily mean that there will be more assets for foreign investors to buy within any reasonable time frame.” Buttressing this argument, Lubin points to the fact that growth in China in nominal bank assets has been considerably higher than the growth in the credit share of GDP – which has risen only from 200% to some 240% in the past seven years, as figure 3/4 lays bare.
This year, Euromoney has heard of several board members of global banks that have lobbied emerging market policymakers to liberalize their capital markets, citing US capital market depth as a key driver for the economy’s outperformance relative to Europe, with its dependence on bank finance. But as Lubin noted: “In a post-Lehman world, it is conceivable that policymakers in EM may have a bias for a banks-based model rather than a markets- based model. The traditional arguments against relying too heavily on markets – that they encourage a myopic investment climate, that they don’t monitor corporate management effectively – might have more resonance these days than they used to.”
EM insanity
It’s too early to tell how the political economy in the large emerging nations will develop in the years ahead. But a clear and present consequence of the supply/demand imbalance is that there is too much money chasing too few assets in emerging markets, says Citi’s Lubin. Emerging markets over the past few decades have been rocked by uneducated herds of foreign investors flocking to yieldy developing markets, only to flee at the first sign of trouble. But the current eurozone crisis has driven a rally of a different sort. In short, the oft-touted emerging market allocation thesis – expanding GDP, cheap global liquidity, fiscal and monetary policy sophistication and better debt metrics – is outdated. In addition to these factors, in light of the eurozone crisis, shifting global risk perceptions and the changes in the global financial industry, emerging market fixed-income markets are increasingly seen as guaranteeing a return on capital and a return of capital. In other words, yield and safety. “The private sector wants to buy EM fixed-income assets, but the supply is not enough when compared with inflows, resulting in a dynamic in which the official sector does not supply sufficient assets to satisfy private-sector appetite,” notes Olgay Buyukkayali, fixed-income strategist at Nomura.
In sum, these forces "set us up in 2012 for what we call EM 'insanity', where inflows into EM bond markets can overshoot – first in credit space, followed by local assets,” Buyukkayali concludes.
There might be some evidence of this dynamic taking place, even in emerging Europe. Underscoring the shortage of investable high-quality sovereign paper, short-term euro-denominated non-eurozone debt, principally Polish debt, flirted with negative yields in mid-July. What’s more, the Markit Itraxx SovX CEEMEA, which comprises 15 sovereign credit default swap markets in the region, has traded through its Western European counterpart.
The prospect for emerging market bonds then is Janus-faced. While most investors and analysts reckon there is a material risk that high-rated bonds will be sold off in any global deleveraging cycle, the structural prospects for the asset class are so compelling that the shortage of its supply is the chief gripe for global institutional investors and banks alike.
Source: IMF