Executive Summary

• Emerging market investors used to be confined to U.S. dollar-denominated (external) sovereign debt, tracked by benchmarks such as the JP Morgan EMBI+. Today, this sub-sector is one of three and is dwarfed by its larger counterparts: local-currency sovereign debt and U.S. dollar-denominated (external) corporate debt. Consequently, emerging market investors are going to have to be savvier and diversify their holdings actively as the region evolves and a single benchmark fails to capture the characteristics of the asset class as a whole.
• Spreads on the JP Morgan EMBI+ index have contracted more than 1,500 basis points in the past 10 years and now stand at all-time tights. Further, with less spread cushion, correlations with U.S. markets are rising and diversification benefits are falling. Investors who passively remain with their status quo allocation to external debt will see their placement along the efficient frontier deteriorate and move towards lower risk and return positions.
• Local capital markets have deepened, become more transparent and today act as a legitimate and more efficient alternative to the banking sector for financial intermediation. Trading volumes have soared and yield curves now extend 30 years in many cases. Local markets are now five times the size of external debt markets.
• Within external markets, the government debt share is falling dramatically and today accounts for barely 40% of the market. Corporations dominate issuance in external markets and most, if not all, of the ensuing growth will come from corporations.

Emerging market bond investors now have the choice of three distinct sub-sectors, each with unique attributes and independently unrepresentative of the asset class as a whole. Emerging market investors used to be restricted to U.S. dollar-denominated (external)¹ sovereign debt, tracked by benchmarks such as the JP Morgan Emerging Markets Bond Index Plus (EMBI+). Today, this sub-sector is one of three and is dwarfed by its larger counterparts: local currency sovereign debt and U.S. dollar-denominated (external) corporate debt. Bond markets in developing countries are beginning to look more like those in developed countries and a single index such as the EMBI+ no longer captures the asset class as a whole. This paper aims to provide a brief explanation for the transformation of this asset class as well as an outline of the new characteristics that investors now face when constructing their portfolios.

The decision to allocate a portion of one's portfolio to emerging market debt is supported by the well-worn concept of the efficient frontier. Emerging market returns are higher than and weakly correlated with U.S. bond returns. Thus, we believe that investors can achieve enhanced returns, reduced risk and a movement upwards towards the efficient frontier with a modest allocation (see Exhibit 1, arrow A). The total amount allocated – the placement along the efficient frontier – is determined by each individual based on his comfort with risk, known as the investor's "beta" position.

The beta of U.S. dollar-denominated sovereign debt has fallen recently and the investor who passively remains with his status quo allocation will see his placement along the efficient frontier move towards a lower risk and lower return position (see Exhibit 1, arrow B). That result may be appropriate but the decision should be made actively.

Emerging Markets – Where We've Been
Spreads on the JP Morgan EMBI+ index have contracted more than 1,500 basis points in the past 10 years and now stand near all-time tights (Exhibit 2). An investor who bought and held the index on 31 December 2001 would have earned more than 9.4% over Treasuries each year. Even the investor who bought the index on 31 December 1995, about a year before troubles surfaced in Asia, would have earned more than 6.6% per year over Treasuries. Today, if spreads remain stable, an investor who buys and holds the index can expect around 2.0% over Treasuries. Furthermore, with less spread cushion, correlations with U.S. markets are rising and diversification benefits are falling. The three-year correlation between the EMBI+ and Lehman's U.S. Aggregate Index has increased to 0.71 from 0.26 ten years ago. The more spreads compress and the longer they remain at historical low levels the further correlation measures will increase.

The spread contraction is not unjustified. Economic reform has been impressive and in fact it is increasingly difficult to define countries along the development spectrum; roughly 40% of the EMBI+ is now rated investment grade, up from 2% at inception in 1993. Growth began diverging from the advanced economies in the early 1990s (Exhibit 3) and the decline in sovereign default probabilities has led spreads lower.

The two new sub-sectors—local currency sovereign debt and external corporate debt—are a natural consequence of the movement by countries along the development spectrum, from developing towards advanced economy status. Not all countries have improved and many still have a long way to go, but recent gains have been the result of a determined effort by policymakers to give the free market more influence in determining economic affairs.

The global economy is enjoying its longest run of rapid growth in decades. High commodity prices have been supportive of even those countries that have done little to generate internal momentum. Nevertheless, even countries that have been slow on institutional reform have taken the opportunity to save much of their windfall income and defer current spending for sustainable spending in the future. Russia, for example, despite mediocre fundamentals, has set aside over $400 billion in the "Future Generations Fund" over the last five years. Capital moves much more freely across international borders today and prudence is rewarded while profligacy is punished. Brazil's Lula da Silva discovered this when he became president in 2002. Spreads on external Brazilian debt initially spiked by 1,800 basis points in reaction to his left-wing rhetoric but subsequently compressed following his investor friendly, pro-growth positions. This aspect of globalisation can explain many of the ups and downs in the emerging world of the past ten years and will likely continue to explain them in the next ten years.

Background
To an economist, there are two strands of globalisation: increased trade in goods and services and increased capital flows. According to the Federal Reserve's Frederic Mishkin, "From 1973 until today, world trade grew at 11% annually, rising from just over 22% of world GDP to 42%. Since 1973 the flows of capital between countries have also exploded, rising from 5% to 21% of world GDP".² While trade in goods and services, or real globalisation, nearly doubled over the period and is now a larger aspect of economic integration, international capital flows increased four-fold and appear set to continue to expand rapidly in coming decades. This second strand of globalisation, or financial globalisation, has significant implications for investors.

It cannot be denied that financial globalisation has also been a disruptive force, creating many of the periodic crises that have destabilised the global economy. Thus, although economists almost uniformly agree that real globalisation is an unequivocal benefit, opinion is mixed on whether financial globalisation has been a blessing or a curse to the developing world. A number of paradoxes have also surfaced. Why, for example, does capital flow from poor to wealthy countries? During the last great globalisation (1870-1914), capital flowed from the wealthy world, where capital was abundant but investment projects scarce, to the poor world, where investment projects were abundant but capital scarce. Today the opposite is true, with poor countries providing the bulk of global savings and acting as a source of liquidity to the global economy.

Ken Rogoff, former director of research at the IMF, shed light on the topic in his exhaustive survey of literature.³ First, in contrast to the traditional view of development according to which a lack of direct access to capital was the primary impediment to growth, Rogoff finds that financial globalisation influences growth indirectly by breaking the lock on power of those who oppose positive economic reform. Poor countries generally have enough capital for their investment needs. The problem lies with the inefficient use of capital; a lack of institutional development, policy discipline and poorly functioning local capital markets lead to counterproductive investments. Rogoff finds that international capital flows act as a catalyst to improve domestic institutions, policy discipline and local capital market development. These collateral benefits of financial globalisation lead to faster economic growth, not access to capital directly. Secondly, financial globalisation only has a positive influence when certain threshold conditions are met. This is one of the reasons development is so challenging to implement in practice. If countries do not meet a minimum level of institutional and financial market development, international capital flows can be destabilising and increase the probability of a crisis. In other words, capital account liberalisation leads to an improvement in the very criteria necessary to insulate an economy from the downside of capital account liberalisation.

Emerging Markets – Where We're Going
Policymakers have taken these insights to heart. There has been a strong push for institutional development to complement capital account liberalisation and the following have materialised as the five key criteria of sustainable economic development:

1. price stability and credible monetary policy;
2. flexible exchange rates;
3. sound financial supervision and regulation;
4. a balanced budget; and
5. the need to limit U.S. dollar-denominated borrowing.

Gains on all five fronts have helped to reduce spreads on external sovereign debt, with the last criteria, the reduction in U.S. dollar-denominated borrowing, creating a new investment opportunity in the process.

Local Markets
As Alan Greenspan remarked in 1999, "The lack of a spare tyre is of no concern if you do not get a flat". Emerging Asia did not have a spare tyre in 1997 when the banking sector went flat, dragging down economic growth with it. Today, most countries have spare tyres. But local capital markets play a larger role than just that of spare tyre to the banking sector. Local capital markets have deepened, become more transparent and today act as a legitimate and more efficient alternative to the banking sector for financial intermediation. Trading volumes have soared and yield curves now extend 30 years in many cases. In 2006, local market issuance grew 18% while trading volume increased 42%. In contrast, external sovereign debt issuance grew 4%⁴ and trading volume declined 1%.⁵ Local markets are now five times the size of external debt markets. The transformation has been propelled by a surge in the supply of and demand for local fixed-income assets.

Supply
Up until the late 1990s, countries primarily issued bonds in U.S. dollars rather than their respective local currencies, attracted to lower borrowing costs and a false sense of security provided by fixed exchange rates. This approach resulted in large currency mismatches on balance sheets: U.S. dollar-denominated liabilities offset by local currency-denominated assets. When local currencies became overvalued, eventually breaking their pegs against the U.S. dollar and in some cases losing 50-75% of their value, balance sheets were devastated. The value of U.S. dollar-denominated liabilities soared by the amount of depreciation while the value of local assets plunged, leaving companies bankrupt and banks insolvent. To eliminate this balance sheet effect, borrowers began carrying out the majority of their financing locally, despite higher borrowing costs in some cases funding the early retirement of external debt with local currency-denominated issuance. The result was a large increase in the supply of local currency bonds and a drop in the supply of external bonds, a technical factor that also helped to push external debt spreads lower.

Demand
Rapid growth of contractual savings institutions, such as pension funds, insurance companies and mutual funds, has easily absorbed the increased issuance. They aim to immunise their local currency-denominated liabilities with assets of the same currency and similar duration. Not only have these institutional investors provided a local captive buying base, but the demand for longer duration assets has resulted in extended yield curves and more transparent and better regulated markets.

A quick glance at Exhibit 5 reveals that U.S. dollar-denominated debt is not diminishing. On the contrary, it has grown 11% annually during the past six years, albeit more slowly than the 18% growth rate of local currency debt. Still, 11% growth almost equals nominal GDP growth in the region. Thus, even external markets are deepening, but not because of government borrowing.

Corporate Issuance
Governments will continue to borrow in U.S. dollars for the benefit of establishing a sovereign yield curve against which corporate issues can be priced. However, the government share is falling dramatically and today accounts for barely 40% of the market. Corporations dominate issuance in external markets (Exhibit 7) and most, if not all, of the ensuing growth in external markets will come from corporations.

Markets for both local corporate debt and equity have lagged the development of the local government bond market. As a result, borrowing from top-tier corporations has focused on external markets instead. Moreover, the decrease in issuance from the sovereign side has allowed increasing numbers of local corporates to "fill the void". However, because of the composition of their revenue and cost streams, corporate borrowers are often in a superior position to borrow externally relative to their own governments. Many have cash flows and assets denominated in U.S. dollars as well as in other currencies highly correlated with the U.S. dollar since trade is conducted globally. Consequently, balance sheet effects are not as threatening. The optimal financing of expanding international operations actually requires some U.S. dollar-denominated debt where the cost of borrowing tends to be lower and better matches dollar-denominated assets. Brazil's CVRD, a global metals and mining company that has ridden the wave of demand for industrial metals, is a good example. In late 2006, CVRD closed on its $18 billion acquisition of Canadian nickel producer Inco. CVRD now derives 35% of its revenues from the Americas, 37% from Asia, 24% from Europe and 4% from the rest of the world. Although it is a Brazilian corporation, approximately 80% of CVRD's assets now reside outside of South America.

Although analyst coverage is thorough, there is generally less awareness among investors of corporate issues relative to their sovereign counterparts. But the value is there. It does take more sophisticated credit evaluation and local market expertise to reveal the most undervalued corporate debt issues. Whereas inflows by international investors grew twelve-fold in the five-year period ending December 2006,⁶ premiums on corporate issues should persist longer than premiums on sovereign issues owing to the heavier due diligence requirements for these types of securities.

Putting It All Together
Economies that have harnessed globalisation have outperformed those that have not. They have progressed along the development spectrum rapidly and created wealth at an unprecedented rate. As a result, investors in the developed world have seen prices of commodities soar and those of tradeable goods plummet, as manufacturing jobs disappear and fears of outsourcing and immigration dominate political discourse. For investors, these are merely second-order ripple effects. Larger changes are taking place in the emerging world and investors directly invested in the region should be cognisant of these changes. Bond markets are beginning to look a little more like those in developed countries and investors must evolve with the asset class in order to maintain a well-diversified and constant beta position.

Unfortunately the growth pattern within the developing world has not been consistent across regions. Many economies, especially in sub-Saharan Africa, have been stuck in a low-growth equilibrium, unable to replicate the success of emerging Asia, Central and Eastern Europe and a number of countries in Latin America. Consequently, indices like JP Morgan's EMBI+ are no longer acting as a conduit for emerging market investors. These indices used to exclude countries that were both too risky and without investable bond markets as well as more advanced countries that were too safe. Unfortunately, there is not a new crop of countries on the brink of inclusion to replace those that have "graduated" out of the index, like South Korea and, most recently, Poland. Instead, emerging market investors are going to have to be savvier and diversify their holdings actively as the region evolves and a single benchmark fails to capture the characteristics of the asset class as a whole.

Notes

1. Technically, "external" refers to all hard currencies, including the euro and yen. This discussion focuses on the U.S. dollar.
2. Frederic Mishkin, The Next Great Globalization: How Disadvantaged Nations Can Harness Their Financial Systems to Get Rich (Princeton: Princeton University Press, 2006), 5.
3. M. Ayhan Kose, et al., "Financial Globalization: A Reappraisal", IMF Working Paper (2006).
4. Source: BIS
5. Source: EMTA
6. Joyce Chang, et al., "Emerging Markets Evolve as an Asset Class", JP Morgan Emerging Markets Research (2007), 37.