Feature


Does this mean that investors should simply ditch their hold- ings? That may be premature, given that emerging markets account for more than half of global GDP, but only a fraction of global investment. In the UK, 37% of defined benefit (DB) schemes are invested in emerging market debt, with an aver- age allocation of 4%, according to Mercer.


Among defined contribution (DC) schemes, 30% are exposed to the asset class, which, on average, accounts for 7% of the port- folio. But given the still relatively low yields in developed mar- kets, the share of emerging markets in pension funds is grow- ing. DB schemes, for example, have increased their allocation by 9% year-on-year and it also accounts for a growing share of DC schemes’ fixed income portfolios, according to Mercer. But with risks mounting, how can investors navigate the com- ing storm?


Dollar trouble How did we get here? One factor that helps explain the grow- ing share of low-and middle-income countries in international debt markets is ultra-loose monetary policy across developed nations, which has pushed interest rates down globally. As a result, the volume of emerging market debt in circulation has doubled to $9.3trn (£7.7trn) from $5trn (£4trn) in 10 years, according to the World Bank. Covid has again accelerated this trend, with the debt stock of emerging markets rising by almost 7% in 2021 alone.


And paying back the rising debt mountain has become a lot more expensive, especially for hard currency debt, which tends to be dollar denominated. The price of the dollar has reached a


20-year high (as of June 2022), pushing up the costs of servic- ing this debt. For many investors, this brings back bad memories of the 2013 taper tantrum, when speculation of a Fed rate hike caused a stampede out of emerging markets. The rising dollar has also caused fund managers to ring the alarm bells. US asset manager Man Group has warned that around 10% of dollar-de- nominated debt is at risk of default. A record 19 emerging mar- ket countries are trading at distressed levels, which amounts to $250bn (£207bn) in debt, according to Bloomberg.


Staying local


While all this is deeply alarming, there is, however, an impor- tant counteracting factor, as Stuart Trow, a columnist and for- mer credit strategist at the European Bank for Reconstruction and Development explains: the share of local currency debt has been increasing. It now accounts for almost all outstanding emerging market borrowings. As of 2018, local currency debt stood at just above $2.2trn (£1.8trn), compared to around $880bn (£729bn) in hard currency, according to JP Morgan.


Nobody can completely escape the dollar, but it would be worse if they didn’t have local currency debt.


Stuart Trow, columnist


This marks a significant change compared to the situation dur- ing the taper tantrum in 2013, when hard currency debt was more prominent. But local currency debt is highly concentrated among the big- gest issuers. For more than 80 emerging countries, hard cur- rency debt remains dominant because investors do not have faith in the stability of their currency. These countries remain exposed to the risks of the rising dollar. “From an investor perspective, there is now a lot more interest in local currency debt, but when you look at the market, a lot of the big issuers, such as Turkey and Russia, have disappeared and China has become less attractive as a local currency invest- ment,” Trow says. “For international investors, the whole point of local currency debt is to wean people off exposure to the dollar,” he adds. “Clearly that is playing a role now. Nobody can completely escape the dollar, but it would be worse if they didn’t have local currency debt.”


It is no wonder then, that international creditor bodies, such as the IMF, aim to promote the development of local currency debt markets as an important source of financial resilience. But local currency debt is by no means a panacea, warns Dinesh Visavadia, a director at Independent Trustee Services. “From a trustee point of view, there is the challenge to consider whether you invest in hard or local currency debt and, of course, hard currency can be more reasonable because you will have more due diligence and governance. With local currency debt, you are always subject to fluctuations in the country’s currency,” he says.


24 September 2022 portfolio institutional roundtable: Emerging market debt


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