EM debt markets are both resilient and vulnerable
Countries with high levels of foreign participation in their domestic debt markets are more likely to face selling pressure when sentiment deteriorates
Investor sentiment towards emerging markets (EMs) has improved markedly over the past several weeks.
The stocks of developing economies have surged 9.5 per cent in dollar terms since the beginning of October - trimming their losses over the past three months to 4 per cent - while many of the most vulnerable currencies have risen against the dollar.
The Brazilian real, the worst-performing major EM currency has strengthened 6.5 per cent versus the greenback since September 23, while the Malaysian ringgit, another currency that has borne the brunt of the deterioration in sentiment towards EMs, is up 5.5 per cent since September 29.
The improvement in market conditions stems mainly from the perception among investors that a further delay in the tightening of US monetary policy may be beneficial for EM asset prices.
Yet without a recovery in commodity prices - Brent crude dropped 3 per cent on Monday following the release of third quarter GDP data for China which, although better than expected, threw the weakness of domestic demand into sharp relief - a meaningful and sustainable improvement in sentiment is unlikely.
All the more reason, then, for investors to take heart from the relative resilience of EM government bond markets.
In stark contrast to the full-blown EM crises during the 1990s when the creditworthiness of developing countries was extremely weak due to severe financial, economic and governance-related problems, the underlying fundamentals of EMs are now much stronger, notwithstanding a sharp slowdown in growth and the loss of the investment grade status of a number of EMs, notably Brazil and Russia.
This is partly why debt markets have weathered the deterioration in sentiment.
According to JP Morgan, while there have been US$56.5 billion in outflows from EM equity funds this year, net flows to EM bond funds are in positive territory - although just. Last year, there were $11 billion in inflows into EM debt funds, compared with $28.5 billion in outflows from EM equity funds.
The average yield on JP Morgan’s benchmark EM local currency government bond index (GBI-EM) currently stands below 7 per cent, roughly where it stood a year ago. The recent China-induced deterioration in sentiment has not had a significant impact on the vast majority of developing countries’ debt markets.
In a telling indication of the resilience and maturity of EM bond markets, the yield on the 10-year local debt of Malaysia, one of the developing countries hardest hit by the China-induced plunge in commodity prices, has barely risen over the past year.
This is all the more remarkable given that the ringgit, Malaysia’s currency, has fallen a whopping 30 per cent against the dollar.
Yet Malaysia’s domestic bond market may be more vulnerable than meets the eye.
Foreigners hold more than 45 per cent of Malaysian local bonds - the highest ratio among the leading EMs, according to JP Morgan.
Countries with high levels of foreign participation in their domestic debt markets are more likely to face selling pressure when sentiment deteriorates sharply given that foreign capital is flightier than local money.
Indeed many EMs which are perceived as relatively stable have large foreign holdings of local bonds, including Poland, Mexico, Hungary and Peru.
JP Morgan notes that foreign holdings of domestic debt “have not declined meaningfully” since the so-called “taper tantrum” in May 2013 when the US Federal Reserve triggered a sharp sell-off in EMs by announcing its plans to begin scaling back its asset purchases.
This increases the scope for selling pressure should sentiment deteriorate more sharply, particularly if the foreigners holding these bonds are speculative investors, such as hedge funds, as opposed to the more committed institutional investors who are less likely to reduce their exposure during periods of market turmoil.
Fortunately, institutional investors account for a large portion of the foreign holdings of EM local debt while domestic investors, such as pension funds and insurance firms, hold the bulk of EM local bonds.
This suggests that even if market conditions in developing economies were to worsen dramatically, domestic investors - who are the least likely to reduce their holdings of local bonds - could pick up the slack in the event that foreigners cut their exposure significantly.
Still, one economy to keep a close eye on is Brazil where, according to JP Morgan, a large portion of the local bonds held by foreigners are owned by speculative investors.
This may partly explain why the yield on Brazil’s 10-year domestic bonds has surged more than 300 basis points since mid-July to nearly 16 per cent.
Not all EM debt markets are resilient.
Nicholas Spiro is managing director of Spiro Sovereign Strategy