Feature


A lot of trustees will be uncomfortable with the level of volatility in local currency debt.


Dinesh Visavadia, Independent Trustee Services


Investment and Baillie Gifford, which have all launched ex-China strategies, according to Blomberg. This does not yet resonate with UK investors. Only 15% of Brit- ish final salary schemes are considering a separate China allo- cation in their emerging market strategy, according to Mer- cer’s asset allocation survey, which was, however, conducted in 2021. But simply ditching China from emerging market strategies opens the door to another problem, that of a rapidly shrinking emerging market universe. With Russia having been booted out of most benchmark indices and Turkey facing skyrocketing inflation (79% at the time of writing), the investable universe has now become quite a bit smaller than it was at the begin- ning of this year, Stuart Trow says.


“A lot of trustees will be uncomfortable with the level of volatil- ity in local currency debt,” Visavadia adds, acknowledging that this means they would have to weigh currency stability versus heightened default risks in hard currency debt.


The China factor


Another factor to consider when investing in emerging mar- kets is the role of China, which thwarts the overall trend. China represents a third of the of MSCI Emerging Market index and is a much more dominant force than it was nine years ago, just prior to the taper tantrum. Back then, China accounted for 18% of the index and the index was, generally speaking, more diver- sified. But now China accounts for more than half of all debt outstanding, owing $2.7trn (£2.2trn) of the $9.3trn (£7.7trn) emerging market debt pile. Chinese borrowing increased 14.4% last year, according to the World Bank. Excluding China, emerging market debt only rose 1.9%. So increasingly, there is an argument to be made that China should be excluded from emerging market debt indices and treated as an entity on its own. As the world’s biggest importer of commodities and given its high debt levels, China was also at the forefront of emerging market outflows. In July alone, €3bn (£2.5bn) of the country’s debt was dumped, according to the Institute for International Finance. Consequently, China has turned from an investor’s favourite to an investor’s foe. This is accelerated by rising commodity prices, where China is effectively importing inflation. Asset managers have responded to this trend by increasingly offering emerging market debt strategies that exclude China. Examples include BlackRock, Amundi, Eastspring, GMO, DFA


Navigating the storm Given the uncertain outlook for a rapidly changing emerging market landscape, how should investors access the asset class? Visavadia says that there is still a lot of opportunity, given that some of the default risks have been priced in, but warns that investors should access emerging markets selectively. Visavadia sees the growing importance of ESG investing as a challenge and an opportunity for emerging markets. “Coun- tries and companies are going on a journey in terms of ESG credibility. There is also a risk here that many may not meet the ESG criteria that international investors are setting and this could add to higher default rates in emerging markets,” he says. In terms of regions, Visavadia is particularly upbeat about Africa and any countries that are exporting commodities. While they have struggled historically, they could now benefit from rising commodity prices, he says. This ties into an argument that Trow is making. Net exporting countries, those with favourable balance of payments, could be relatively more resilient to the impact of the rising dollar and rising energy prices. While oil exporters, such as the Gulf States, stand to benefit in the short run, but in the long run countries able to contribute to the renewable energy transition could become some of the key beneficiaries.


And there are good examples of pension funds banking in on this trend. Earlier this year, a collaboration between 12 UK pen- sion funds, led by The Church of England’s Pensions Board, was announced, which aims to fund the climate transition in emerging markets. This includes USS, BT Pension Fund, Railpen, Brunel Pension Partnership, Border to Coast Pension Partnership, Nest and Legal & General Workplace Pension Plan, which collectively manage more than £400bn in assets. They will join forces to invest in the energy transition across emerging markets. An indication that the way UK institutional investors are accessing the asset class is rapidly changing.


September 2022 portfolio institutional roundtable: Emerging market debt 25


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