There is an old joke that says that an emerging market is one you cannot emerge from in an emergency. Originally penned by the journalist Christopher Fildes, it never loses its relevance. What makes it timely once again today is the dramatic fallout in the local currency emerging debt markets.
Two weeks ago I raised the question of whether emerging market debt could be regarded as a safe haven in the light of the strengthening of country balance sheets in the developing world. The accumulation of reserves, declining debt levels and relatively high yields had caused some investors to argue that emerging markets, especially those in Asia, provided a better bolt-hole for the nervous. And indeed this asset class, traditionally regarded as very risky, stood up well in the period of risk aversion that struck the markets in August.
The maelstrom of the past two weeks, in which most emerging market local currency debt has taken a sickening downward lurch, has confirmed my scepticism. One of the best investment stories of the past 10 years has run into a brick wall. Indeed, most emerging markets should now be regarded as unsafe havens.
The cause of this setback is the sovereign debt crisis in the eurozone and the growing concern about the gloomy economic outlook as propounded by the US Federal Reserve last week. Far from being decoupled from the developed world, as many believed, emerging markets are suffering from contagion. More specifically, they are the victims of a decline in market confidence that has prompted a flight to US government bonds.
So where does that leave the related and increasingly popular asset class, emerging market currencies? The long run case for these currencies is that they are prone to structural appreciation as the developing world closes the gap in living standards with the developed world. The twist to the argument lies in emerging markets’ resort to currency pegs, notably in Asia, which leads to excessive reserve accumulation and huge imbalances in the global economy. In the most egregious case, that of China, official reserves are now more than $3,000b.
The opportunity cost of investing these funds in dollar assets with a negligible current yield and the potential for vast capital losses will be enormous as emerging market currencies appreciate. So a conspicuous misalignment between current currency values and underlying fundamentals cannot continue forever.
Then there is the shorter term argument that because emerging markets have been overheating, they are bound to resort to currency appreciation to help curb inflation. Yet this has now been blown by the global slowdown and the fall in commodity prices, which means that inflationary pressure is lessening. That suggests monetary policy will loosen, removing upward pressure on currencies. And in some countries such as Brazil, interest rates have been cut despite persistently high inflation.
The risk now is that some of the most crowded trades in the world involve long positions in emerging market currencies funded by short positions in the dollar or yen. Such funding with haven currencies is potentially catastrophic. So far it is only the most nimble investors that have emerged from these currencies. A more extensive unwinding could be highly disruptive.
As Mike Riddell of M&G Investments argues, some scary things are at work. Ten years ago, emerging market local currency debt was small beer and almost entirely domestically owned. Today foreign ownership is about 30 per cent. That may not sound high, but some holdings are concentrated in markets that are neither liquid nor deep.
There are, says Mr Riddell, a handful of enormous global bond investors with a heavy exposure to local currency emerging market debt, with some owning more than 50 per cent of individual sovereign bond issues. A reversal of the huge capital inflows into emerging market debt would thus confront a total lack of liquidity and inflict much higher borrowing costs on the countries concerned.
It could then become nastier still because governments are not the only ones to rely on these capital inflows and the cheap financing that they entail. Banks and the non-financial corporate sector may also be in a similar position.
True, there is little currency mismatch on the kind of scale that proved so damaging in the Asian crisis of 1997-98. Yet the scope for an abrupt change of financial gear remains disturbing. The risk is that if the eurozone debt crisis worsens, a further flight to the dollar will cause more damage to emerging market local currency debt. It seems unlikely that policymakers’ deliberations in Washington this weekend will convince the markets that a compelling solution to the eurozone problem is imminent.
The irony, as I argued here two weeks ago, is that the dollar is not really a safe haven any more. The escalating US public sector debt means that it is merely a liquidity haven. But you can at least emerge from it in an emergency.
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