Turbulent Times but Economic Convergence Continues
Western Asset
November 13, 2008
Market Review
Until September, emerging market bonds had largely avoided the heavy selling pressure that afflicted other risky asset classes during the past year and a half (Exhibit 1). U.S. dollar-denominated debt had sustained only a gentle repricing, and currencies strengthened relative to the U.S. dollar. U.S. and European banking supervisors had even hoped that emerging markets sovereign-wealth funds would help recapitalize their beleaguered banking systems.
That all changed in mid September (Exhibit 2). Indiscriminate selling began as investors rushed to hoard cash following the failure of Lehman Brothers. Volatility spiked to unseen levels, further pressuring leveraged players who sold what they could, not what they wanted, in an effort to meet margin calls (Exhibit 3). Corporations headquartered in emerging countries were forced to unwind short positions in U.S. dollars, which had been put in place to hedge dollar revenue-streams back to their local currency. The Brazilian real lost over a quarter of its value in the span of a couple of weeks and remains under pressure to this day.
Commodity prices plunged and expectations grew that consumption in advanced economies would slow more than initially believed. Investors began to question the sustainability of the export-led growth model prevalent throughout the emerging market world. It has been a great run, but are the good times over for emerging markets?
Making Sense of the Current Environment Vulnerabilities Abound: The Bear’s Argument The export sector is the dominant engine of economic growth. While emerging markets’ exports have been increasingly directed to other emerging markets—up to 50% from just 30% in the 1970s—advanced economies still absorb a full 50% of total exports from emerging markets. China’s annual GDP through the third quarter, in fact, suggest that much of the decline in growth to 9% from over 12% was due to a slowing export sector. The slowdown in external consumption should continue to dampen emerging market growth for the next few years, putting a serious strain on the growth model employed across the region.
More concerning, the global desire to hoard cash in U.S. T-bills has compromised the ability of emerging market borrowers to roll over short-term liabilities. We have already seen illiquidity drive insolvency in the U.S. banking sector. Thus, market participants currently fear that this could happen at the sovereign level. Many emerging market banking systems are currently contending with both internal and external drains. Residents in emerging markets are withdrawing deposits from domestic banking systems (internal drain) and capital is fleeing to advanced economies (external drain). This is exactly what occurred during the home-grown crises of the past. The trigger may be different this time, but the dynamic remains the same. If a wealthy country like Iceland can flirt with default, couldn't the same happen to Russia?
Leading up to the crisis, private capital inflows from international investors grew to rival the peak set just before the 1997 Asian crisis (Exhibit 4). For example, since June 2005, growth in borrowing from U.S. and European banks during the past three years ranged from a high of 989% in the Ukraine to a low of just 24% in the Philippines. Loans grew by 133% in Brazil, 97% in Hungary, 38% in Mexico and 306% in Russia. These private inflows, often intermediated by advanced economy financial institutions, are now abruptly ending, just as they did in 1997. Regardless of the solvency of the banking systems or soundness of the growth model, this sudden stop in liquidity flows can be devastating to any country.
Policy Flexibility: The Bull’s Argument
This is neither the 1997 Asian crisis nor the 1994 Mexican “Tequila” crisis, when an overreliance on foreign capital to fund excessive risk-taking combined with a fragile institutional framework to trigger a currency crisis, which in turn triggered a domestic financial crisis. The excessive risk-taking was bad enough, but the fragile institutional framework was the killer. Today, conditions are in stark contrast. Institutional frameworks are much improved, and prudence has ruled the day. The excessive risk-taking occurred in advanced economies, not emerging markets, and was funded by foreign capital inflows from the emerging markets themselves.
Since the late 1990's, government budgets have swung towards surplus. Many countries have run large trade surpluses year after year, accumulating an inexplicably large stock of reserves in the process. Deepening local capital markets replaced external debt, reducing currency risk in the process (see Box 1). For example, Brazil's Gerdau, Latin America's large steelmaker, should benefit from the depreciation of the real. A large portion of Gerdau's revenues are denominated in U.S. dollars while costs are predominantly in real. The recent depreciation of the real may even be beneficial enough to offset the recent fall in steel prices.
IMF conditionality attached to loans made during past crises usually required central bank independence and explicit inflation targets. Inflation fell to single digits as a result, where it remains today. This permitted a switch in currency regime from pegged to (quasi) floating, and currencies now help to cushion exogenous shocks rippling across the oceans from the 'wealthy world'. Today, rather than wipe out foreign currency reserves and stoke inflation fears, currencies are free to depreciate and improve a country's competitiveness vis-à-vis its trading partners.
Even countries that had made limited fundamental improvements-Russia and Venezuela to name two-at least set aside a large portion of their newfound commodity-derived wealth for a rainy day. Past commodity booms typically resulted in pro-cyclical fiscal policy and impaired competitiveness for the non-commodity producing part of the economy. This time around, counter-cyclical fiscal policy is in place, and manufacturing exports continued to grow rapidly in both value and volume terms throughout the commodity price boom.
The current turmoil is an advanced economy financial crisis beget from undercapitalized U.S. and European banks. Emerging market banks held few, if any, of the subprime mortgage assets that have destroyed trust in U.S. and European banking communities. Emerging market governments have tapped their vast capital reserves, quickly injecting tens of billions of dollars into domestic banks to ensure they remain well capitalized and functioning properly. Russia has already injected more than $200 billion into its banking system; Kazakhstan has pledged $5 billion to its four largest banks, $3.5 billion of which has already been accepted. In the case of Kazakhstan, the government has already begun to define the post-crisis system by selecting the nation's four strategically important banks for recapitalization, which could amount to roughly 25% of each bank's respective capital base.
Investment Approach
Generally, our analysis begins with a vulnerability assessment. If a country appears to be excessively vulnerable to either a slowdown in exports or a sudden stop in capital flows, we then consider policy flexibility. In particular, we ask whether policy-makers have sufficient tools at their disposal to contend with such a crisis in confidence that may last for an extended period. Vulnerability primarily involves the degree to which growth has been fuelled by foreign capital. As discussed, the growth in lending from U.S. and European banks is a prime metric. In contrast, a country with a large current account surplus, a disproportionate composition towards FDI and a strong deposit base in the domestic banking system would suggest lower levels of vulnerability. Russia was singled out early and suffered large capital outflows because of a heavy reliance on foreign funding for loan growth. The Ukraine, with its 989% loan growth, is a very vulnerable country. Turkey, with close to a 7% current account deficit, is also vulnerable. But policy flexibility can often compensate for these weaknesses.
The Fiscal Option
Policy flexibility includes large capital reserves that can be used either to ensure the domestic banking system remains well-capitalized, or to alleviate rollover risk and ensure that imports continue to remain funded. Russia has sufficient reserves to cover nearly two years of imports, the third-largest stock of official U.S. dollar-denominated wealth in the world. The government’s budget is running a 6% surplus and the supply of external debt is small at only 6% of GDP. Meeting coupon payments on such a small principle is simply not a burden. The Kremlin has ample room to engage in counter-cyclical fiscal policy.
The Monetary Option
While Brazil has reserves in excess of a full year of imports, and thus a degree of fiscal flexibility, monetary policy is the source of flexibility here. Real interest rates are high at close to 7% and inflation is relatively low at 6.4%. Inflation is falling towards the central bank’s target of 4.5% after the recent temporary commodity price spike. Thus, the central bank has room to operate, and its inflation-fighting credibility should ensure that currency depreciation is not offset by rising inflation expectations.
Portfolio Positioning
Generally, with spreads in external markets — both sovereign and corporate — now three times year ago levels and currency volatility sky high, we have shifted our focus back towards U.S. dollar-denominated markets, away from local markets (Exhibit 6). We recently reduced positions in the Turkish lira and the Indian rupee, and are taking a serious look at select dollar-denominated issues that we feel offer compelling risk-adjusted return potential. We will continue to emphasise corporate debt over sovereigns where spreads have reached compelling levels and more than offset any additional risk.
The Longer-Term Perspective
Fundamental macroeconomic improvements have been remarkable during the past decade. Cyclical decoupling is not yet a reality, but secular decoupling occurred in the mid-1990s (Exhibit 7). GDP growth has been, on average, nearly triple that of advanced economies, helping per capita GDP levels finally begin to converge towards those in the advanced world. The IMF forecasts that the gap will widen to four or five times over the next five years given the relatively sharper slowdown in the U.S. and Europe. Vulnerabilities abound given near-term strains, but the long-term convergence story remains firmly in place.
While the magnitude of the current financial crisis is unprecedented, so also has been the global policy response. The market has become exceedingly focused on near-term access to liquidity, largely obviating the impact of strong longer-term solvency indicators. Assuming that market interventions by the IMF and governments across the globe succeed in sustaining some level of financial market and economic function, trust in the system will eventually recover and technical selling pressure will forfeit its dominance to fundamental evaluation once again.
Western Asset Management Company Limited is authorised and regulated by the Financial Services Authority. Western Asset Management Company Limitada is authorized and regulated by CVM – Comissão de Valores Mobiliários. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business and investment management business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number 011-01319).
Western Asset
November 13, 2008
Until September, emerging market bonds had largely avoided the heavy selling pressure that afflicted other risky asset classes during the past year and a half (Exhibit 1). U.S. dollar-denominated debt had sustained only a gentle repricing, and currencies strengthened relative to the U.S. dollar. U.S. and European banking supervisors had even hoped that emerging markets sovereign-wealth funds would help recapitalize their beleaguered banking systems.
That all changed in mid September (Exhibit 2). Indiscriminate selling began as investors rushed to hoard cash following the failure of Lehman Brothers. Volatility spiked to unseen levels, further pressuring leveraged players who sold what they could, not what they wanted, in an effort to meet margin calls (Exhibit 3). Corporations headquartered in emerging countries were forced to unwind short positions in U.S. dollars, which had been put in place to hedge dollar revenue-streams back to their local currency. The Brazilian real lost over a quarter of its value in the span of a couple of weeks and remains under pressure to this day.
Vulnerabilities Abound: The Bear’s Argument
The export sector is the dominant engine of economic growth. While emerging markets’ exports have been increasingly directed to other emerging markets—up to 50% from just 30% in the 1970s—advanced economies still absorb a full 50% of total exports from emerging markets. China’s annual GDP through the third quarter, in fact, suggest that much of the decline in growth to 9% from over 12% was due to a slowing export sector. The slowdown in external consumption should continue to dampen emerging market growth for the next few years, putting a serious strain on the growth model employed across the region.
This is neither the 1997 Asian crisis nor the 1994 Mexican “Tequila” crisis, when an overreliance on foreign capital to fund excessive risk-taking combined with a fragile institutional framework to trigger a currency crisis, which in turn triggered a domestic financial crisis. The excessive risk-taking was bad enough, but the fragile institutional framework was the killer. Today, conditions are in stark contrast. Institutional frameworks are much improved, and prudence has ruled the day. The excessive risk-taking occurred in advanced economies, not emerging markets, and was funded by foreign capital inflows from the emerging markets themselves.
Generally, our analysis begins with a vulnerability assessment. If a country appears to be excessively vulnerable to either a slowdown in exports or a sudden stop in capital flows, we then consider policy flexibility. In particular, we ask whether policy-makers have sufficient tools at their disposal to contend with such a crisis in confidence that may last for an extended period. Vulnerability primarily involves the degree to which growth has been fuelled by foreign capital. As discussed, the growth in lending from U.S. and European banks is a prime metric. In contrast, a country with a large current account surplus, a disproportionate composition towards FDI and a strong deposit base in the domestic banking system would suggest lower levels of vulnerability. Russia was singled out early and suffered large capital outflows because of a heavy reliance on foreign funding for loan growth. The Ukraine, with its 989% loan growth, is a very vulnerable country. Turkey, with close to a 7% current account deficit, is also vulnerable. But policy flexibility can often compensate for these weaknesses.
Policy flexibility includes large capital reserves that can be used either to ensure the domestic banking system remains well-capitalized, or to alleviate rollover risk and ensure that imports continue to remain funded. Russia has sufficient reserves to cover nearly two years of imports, the third-largest stock of official U.S. dollar-denominated wealth in the world. The government’s budget is running a 6% surplus and the supply of external debt is small at only 6% of GDP. Meeting coupon payments on such a small principle is simply not a burden. The Kremlin has ample room to engage in counter-cyclical fiscal policy.
While Brazil has reserves in excess of a full year of imports, and thus a degree of fiscal flexibility, monetary policy is the source of flexibility here. Real interest rates are high at close to 7% and inflation is relatively low at 6.4%. Inflation is falling towards the central bank’s target of 4.5% after the recent temporary commodity price spike. Thus, the central bank has room to operate, and its inflation-fighting credibility should ensure that currency depreciation is not offset by rising inflation expectations.
Generally, with spreads in external markets — both sovereign and corporate — now three times year ago levels and currency volatility sky high, we have shifted our focus back towards U.S. dollar-denominated markets, away from local markets (Exhibit 6). We recently reduced positions in the Turkish lira and the Indian rupee, and are taking a serious look at select dollar-denominated issues that we feel offer compelling risk-adjusted return potential. We will continue to emphasise corporate debt over sovereigns where spreads have reached compelling levels and more than offset any additional risk.
Fundamental macroeconomic improvements have been remarkable during the past decade. Cyclical decoupling is not yet a reality, but secular decoupling occurred in the mid-1990s (Exhibit 7). GDP growth has been, on average, nearly triple that of advanced economies, helping per capita GDP levels finally begin to converge towards those in the advanced world. The IMF forecasts that the gap will widen to four or five times over the next five years given the relatively sharper slowdown in the U.S. and Europe. Vulnerabilities abound given near-term strains, but the long-term convergence story remains firmly in place.
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Western Asset Management Company Limited is authorised and regulated by the Financial Services Authority. Western Asset Management Company Limitada is authorized and regulated by CVM – Comissão de Valores Mobiliários. Western Asset Management Company Pty Ltd ABN 41 117 767 923 is the holder of the Australian Financial Services Licence 303160. Western Asset Management Company Pte. Ltd. Co. Reg. No. 200007692R is a holder of a Capital Markets Services Licence for fund management and regulated by the Monetary Authority of Singapore. Western Asset Management Company Ltd is a registered financial instruments dealer whose business is investment advisory or agency business and investment management business with the registration number KLFB (FID) No. 427, and a member of JSIAA (membership number 011-01319).