The switch away from local currency debt

Previous crises have taught investors to be wary of imbalances and asset bubbles, whether these are in housing, credit, equities or indeed debt. But what is the true impact of foreign participation in emerging (EM) debt markets and do these levels of external debt make for an increasingly vulnerable situation?

While non-resident holdings of emerging market debt are rising, this is in line with the development of these countries’ financial markets. It is true that low global interest rates and high levels of liquidity have accelerated flows into EMs.

But this trend was established well before the 2008 financial crisis and it should continue, in a prudent manner, if these markets continue on their path of development.

In 2012 there were record inflows into emerging market debt with net flows of £59.6bn ($94.1bn) surpassing the previous high of $80.0bn set in 2010. However, of note is that unlike 2010, the majority of last year’s flows ($69.8bn) went into dollar-denominated emerging market debt rather than local currency denominated debt.

In fact, local currency debt had a relatively mediocre year in terms of flows, receiving only half the amount that the asset class received in 2010. While 75 per cent of 2012’s EM debt inflows moved into hard currency denominated debt, looking ahead hard currency will lag behind both local currency and corporate debt with investors looking towards the more attractive valuations of the latter.

Relatively large allocations to emerging markets debt have prompted questions over the amount of debt held by foreign investors, given that in some markets such as Turkey, Hungary and Brazil, the level of foreign participation within the local currency bond markets has in some cases almost doubled in the past two years.

In a representative universe of larger emerging markets the total amount of external debt, both public and non-public, has increased from $1.6trn to $5.2trn. However, the growth in external debt has lagged the growth in these economies. Relative to gross domestic product (GDP), external debt has decreased from 31 per cent to 21 per cent over the same period. More importantly, the level of total short-term external debt relative to foreign exchange reserves, a key measure of a country’s vulnerability to funding shocks, has fallen from 42 per cent to 33 per cent. Similarly, the level of external debt to current account receipts has fallen.

While foreign participation in emerging debt markets has increased, levels still seem manageable. In fact the majority of countries in this universe have more sustainable levels of external debt now than they held leading up to 2008.

Are these increasing levels of foreign participation an abnormality which might reverse or are emerging markets following a natural progression towards a more integrated and sustainable funding structure?

Analysis based on IMF and Moody’s data looked at levels of public external debt as a percentage of general government debt for a range of emerging markets, both in 2004 and 2012.

Comparing this with the same analysis in developed markets shows that relative levels of foreign participation are higher in developed markets than emerging markets.

Within the eurozone countries a higher level of foreign participation should perhaps be expected. Even so, given emerging markets’ relatively strong economic fundamentals and low levels of total debt, it is perhaps not surprising that they too have high levels of foreign participation.

Analysing the percentage of total government debt issued on international markets, while individual country experiences do vary, it is very clear that the overall trend is one of convergence towards developed market levels. This is even apparent when China is excluded because its large total debt size combined with low levels of international debt positively distorts the emerging markets totals.

Thanos Papasavvas is a strategist on the fixed income and currencies team at Investec Asset Management