Twenty years ago, many EM countries were experiencing rampant inflation and building up high levels of debt. This culminated in the Latin American debt crisis, where there was widespread default on bank debt owed by sovereign entities.
During the 1990s, several countries (including Mexico, Korea and Russia) came close to default on sovereign debt and others (including much of Asia) experienced severe currency crises and banking collapses.
In 2001 Argentina actually defaulted on its sovereign obligations. It is a result of these painful experiences that has lead to the significant improvement in EM credit fundamentals prevalent today.
The genesis of most of the EM crisis listed above was a policy of pegging domestic currencies to a hard currency, usually the USD. Over time these became overvalued leading to large current account deficits. Ultimately these became unsustainable since foreign investors became unwilling to finance them. Defending such unsustainable currency regimes led to a loss of reserves which ended in either devaluation or in extreme cases, default.
Most EM currencies are fully flexible. This provides shock absorber should there be a growth or balance of payments shock, while allowing central banks to not only preserve but build foreign exchange reserves.
Sovereign balance sheets are now very strong. In many countries the level of central banks foreign exchange reserves exceeds that of external sovereign debt which is a reversal of the situation of the 1980s and 1990s. Additionally most EM countries have independent banks which have explicit inflation targets.
One major by product of the 2008 financial crises was significantly higher fiscal deficits and overall debt levels in many developed countries. By contrast, many emerging market countries had already embarked upon periods of deleveraging ahead of the crisis as they responded to the macro economic crisis of the 1980s and 1990s - engaging in a considerable effort to modernise and strengthen their fiscal policy frameworks.
Debt-to-GDP ratios across emerging countries have been averaging 32 per cent, compared with the ratios in excess of 100 per cent by many developed economies.
The attractiveness of EMD is not only about improving fundamentals. EMD markets have also become significantly deeper and more diversified. Since Mexico’s inaugural foray in to the EM sovereign Eurobond market in the early 1990s, the asset class has expanded. There are more than 50 countries active in sovereign external debt space.
While there is an active foreign exchange market available in around 40 EM countries, it is within local government bond markets that development has been most significant. There are between 15 and 20 countries with yield curves extending 20 to 30 years. Governments are issuing both nominal and inflation linked paper.
Richard House is head of emerging market debt at Standard Life Investments
EXPERT VIEW
Tristan Hanson, head of asset allocation at Ashburton:
“After such strong performance, spreads on hard currency EM bonds are now approaching the pre-Lehman lows achieved during the mid-2000s credit bubble. In terms of local currency debt, real interest rates have collapsed in most EM countries (Figure 1), as concerns over weak global growth and currency appreciation have dragged policy rates lower.
“Generally speaking, low real rates may be here to stay as long as monetary policy remains loose in developed markets. But it is also likely that low rates make EM bonds a riskier proposition going forward. Bond market performance may become more divergent and currency movements will likely become the dominant driver of returns.
