News & analysis
EMERGING MARKET DEBT: THE GREAT DIVERGENCE
The prospect of Fed tightening has sparked a divergence in emerging markets with local-denominated debt benefiting at the expense of hard currency. But how vulnerable is the asset class to another taper tantrum? Mona Dohle reports.
Belts tend to tighten at the start of a new year following a period of festive overindulgence. This usually applies to people, but with inflation on the rise this year it could also apply to central bank balance sheets. In the case of the latter, the indulgence lasted almost 15 years and monetary tightening could have far reaching ramifications for the global economy. One asset class likely to feel the pinch is emerging market debt. The experience of the last episode of tightening was not great. In 2013, the mere mention that the US Federal Reserve was considering reducing the pace of its bond purchases caused emerging market investors to dump their holdings en masse and retreat to developed market assets. This in turn caused the value of domestic currencies to fall, a double whammy for developing economies. At the time, institutional exposure to emerging markets was limited. But after more than a decade of record-low interest rates, institutional investors in the UK have gradually increased their allocations to the asset class. Almost 40% of defined ben- efit funds are invested in emerging market debt, up from 28% in 12 months, according to Mercer’s Asset Allocation Survey. On average, it accounts for 4% of portfolios. Defined contribu- tion exposure to emerging markets is also on the rise with a third of such schemes invested in the asset class, accounting for 7% of portfolios.
Whether or not monetary tightening could affect emerging market portfolios negatively will depend largely on the type of debt investors are holding.
Early birds Fund flow data throughout the past year indicates that a slow- down is on the way. In December, emerging market debt (ex- cluding China) suffered $9.6bn (£7bn) of outflows, compared to $25bn (£18.3bn) of inflows a year earlier, according to the Institute of International Finance (IIF). Key drivers behind investors selling these assets are concerns of persistent Covid risks combined with the fear that inflation will lead to monetary tightening, said Jonathan Fortun, an IIF economist. “Inflation is forcing the hand of policymakers across the EM landscape. Consequently, our tracker shows bond flows diminishing, as 15 of 20 major EM central banks have tightened monetary policy since May,” he added. But there are significant differences to the 2013 taper tantrum.
Many developed market central banks pre-empted the Fed’s move this time around and raised rates in anticipation. Of the 20 biggest emerging market central banks, 12 have raised interest rates. This includes those in Russia, China and many South American countries from Brazil to Mexico and Chile. As a result, many investors are increasingly bullish on local currency debt, anticipating that central banks will succeed to ward off inflation. There are early indicators that investors are preferring local currency over hard currency debt. Over the past three months, Bloomberg’s Local Currency Government Bond Index grew by 1% while the equivalent hard currency index fell 2.8%. Another reason for cautious optimism is that the investor base for emerging market debt has become much more diversified, with domestic institutional investors now holding a much larger share of debt, which could make them less prone to sudden outflows.
Covid risks But there are equally good reasons for approaching the asset class with caution. While debt-to-GDP ratios have come down signifi- cantly during the past decade, the Covid pandemic has reversed that trend. Emerging market debt rose to a record $92.6trn (£67.9trn) in the past year, or 63% of GDP, according to IIF. While developed markets have financed their Covid response largely through helicopter money, many countries have had less monetary autonomy and had to raise cash to tackle the pandemic through foreign currency bonds at high premia. Several UK investors have increased their exposure to hard currency debt over the past year to capitalise on rising borrow- ing costs, such as the Pension Protection Fund. Many emerging markets continue to have high financing needs. The IMF estimates that tackling the Covid pandemic across the developing world will cost more than $3trn (£2.2trn), most of which will be raised through public debt markets. Meanwhile, the central bank rate hikes attempting to fend off inflation have so far had a limited effect. Despite rate hikes, inflation in many emerging markets has risen significantly in recent months. In Brazil it reached close to 10% by the end of 2021. This could potentially reverse the recent trend to local currency debt and spark political unrest as many countries are already facing a cost-of-living crisis. Pension schemes invested in these assets are facing the risk of default and the ethical dilemmas that come with lending to countries that could be forced into severe public sector cutbacks to re-pay the debt. This year marks the 40th anniversary of the Latin American sovereign debt crisis, which started off in Mexico and rapidly led to painful defaults across the region. Four decades on, the countries most exposed to default risks remain those with weak currencies, low foreign exchange reserves, high levels of foreign currency debt and rising inflation levels. One can only hope that history does not repeat itself.
Issue 110 | February 2022 | portfolio institutional | 7
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