Fear and Loathing in Emerging Markets: EM Investing After the Crisis
Jonathan Prin, Head of Research, Greylock Capital
Published: 26 July 2017 01:37
When it became apparent, after the collapse of Lehman Brothers, that the global economy was encountering something more than just an ordinary downturn, most market observers were certain they knew what was in store for emerging markets. After all, the three decades prior to 2008 were littered with crises in developing economies from Mexico to Malaysia. Still, while the worst never came to pass for EMs after 2008, a huge liquidity mismatch has persisted since.
It was certainly true that, until 2008, emerging economies had been growing, and there was no particular reason for EM investors to expect that they would become victims of a crisis of confidence as Lehman unravelled. But periods of panic in EM had become defined by contagion, where a decline in one market led to the decline of a second market, even without any obvious reason why the second market should be influenced by the first.
In some cases, contagion made sense. If two small emerging economies sell similar products on the world market, a decline in the first country's currency could place pressure on the exports of the second country. Similarly, during the European ERM crises of the early 1990s, the fall of the British pound was expected to reduce the competitiveness of French exports – calling into question the ability of France to remain committed to the fixed currency that eventually became the Euro.
Far less obvious, however, was the economic reasoning linking past declines of the Argentine peso to declines in the Mexican peso. Or why the currency crises of Malaysia and Indonesia led to pressure on the economy of South Korea. In both cases, the latter countries are separated by great geographical distances from the former, and the shape of their economies bear little resemblance.
Of course, these market reactions do not necessarily need to be explained by economic fundamentals. One just assumes that panic caused investors to reduce all sorts of holdings, which, when combined with some opportunistic speculative attacks, created a cycle which led to currency runs and bank failures, regardless of economic justification.
So, the expectations of market pundits during the collapse of Lehman were understandable, grounded as they were in the experience of the past thirty years. Emerging markets had been received substantial foreign investment, and that investment was sure to shrivel up as the financial crisis evolved. If those economies didn't deserve the market punishment they received, so what? Nothing had prevented contagion before, and there was no reason to believe that the experience of 2008 would be any different.
The outcome, however, was better than many had expected. Although growth in output from EM economies collectively experienced substantial decline, there were no balance of payments or currency crises, and no widespread bank failures comparable to those of the past. The market also demonstrated an ability to distinguish between emerging markets, both during the crisis and since. During the 2013 "taper tantrum", most of the fallout was limited to the fragile five, all of which had large current account deficits, and so should have been expected to be sensitive to Fed policy.
It is difficult, even in retrospect, to identify what exactly changed to keep contagion mostly contained through the crisis of 2008 and beyond. But reforms implemented through the hard-won lessons from the past, combined with the arrival of new forms of capital, surely helped EM avoid a harsher outcome.
The Washington Consensus
By 2008, many formerly crisis-afflicted countries had implemented what came to be referred to as the 'Washington Consensus', a set of policy prescriptions that recommended low amounts of external debt, high levels of hard currency reserves, and flexible exchange rates. This allowed most EM central banks to respond to the Lehman collapse without having to defend a currency at the same time.
The fiscal discipline practiced by EM countries meant that the average sovereign debt level for several years after 2008 remained relatively stable at 35% of GDP. By 2012 the major EM bond index reached an investment grade rating for the first time. This allowed new types of investors - primarily large institutional investors whose portfolios required an investment grade rating for their portfolios - to begin allocating funds to EM. The result was a dramatic influx of funds that offered a new form of financing to developing economies and corporations.
A Growing Asset Class
Investors had reason to be looking for new opportunities in the aftermath of the financial crisis. Central bankers, especially the Fed and ECB, responded to the crisis by cutting their policy rates to nearly zero (or occasionally even below); the yields of longer-maturity government bonds correspondingly fell to historically low levels.
In an environment with disappearing returns, the demand for securities with meaningful coupons led to an increased interest in EM debt from both sovereign and corporate issuers. Between 2004 and 2012, EM fixed income funds received US$340bn of inflows, US$230bn of which came after the 2008 crisis. The EM corporate dollar bond market has now reached nearly one trillion dollars outstanding.
Much of this new capital came from funds mandated to invest in EM debt. This has helped to mitigate the "capital flight" that was a distinctive feature of past EM calamities. A reverse in investor interest (i.e., outflows) would of course make these outstanding bonds more difficult to re-finance, but in the meantime EM borrowers, particularly the corporate ones, have in aggregate benefited from the influx of capital. In particular, bonded debt partially replaced shorter-term bank financing, which in almost every past EM episode was responsible for turning what could have been an unpleasant but manageable downturn into a catastrophe.
Bonds Fill the Lending Gap
Throughout much of the 1990s, foreign banks had been happy to lend to the rapidly growing economies of southeast Asia through their local subsidiaries. When they suddenly became concerned about the ability of their borrowers to repay, they managed to create both a banking crisis AND a currency crisis. These crises led to a deep slump in output, not only in the economies that had seen the sharpest increase in lending, but in other Asian economies as well.
Following the 2008 financial crisis, bank lending to EM countries declined again. This time, however, the capital flight from banks was partly offset by the influx of dollars from dedicated funds, which provided not only a new source of capital, but one that possessed some important advantages over the bank loans they replaced.
The primary benefit of bond financing for borrowers is that bonds typically have a longer maturity than bank loans, partly alleviating the 'double mismatch' that had been present during the Asian crisis. The majority of bonds in the major EM corporate indices have a maturity of over five years, a substantially longer time frame than most bank facilities. And unlike many bank "demand" facilities, which can be called on short notice, most bonds are not ordinarily permitted to request repayment of their principal before the maturity date, making borrowers less vulnerable at moments of stress.
Bond financing has extended the maturity structures of many corporate borrowers. While this has arguably dampened volatility at the borrower level, the growth of the bond market has exposed investors to a different sort of risk: the (in)ability of the secondary market to efficiently rotate bonds among holders with different tolerances for features like liquidity and risk.
The End of Liquidity
Policy makers reacted to a financial crisis that could trace its roots to banks' exposure to securities of questionable quality by imposing regulations designed to limit the ability of those banks to hold large quantities of bonds for their own account. The recent febrile growth of the EM debt market has occurred in the context of increased issuance of bonds of all types. Even as that growth has occurred, however, an opposite evolution has been occurring at the fixed income desks responsible for making markets in these securities: the amount of inventory held by dealers has fallen sharply. This reduced inventory – a proxy for bond market liquidity – means that even though there have never been more EM bonds outstanding, they have never been more difficult to buy and sell.
The implications of this reduced liquidity will become apparent when investor interest in EM debt begins to wane. It is easy to imagine an environment where sellers, competing to transfer their holdings to trading desks with limited capacity to accommodate them, increasing volatility in those issuances that exceeds any deterioration in underlying creditworthiness.
The worst fears for EM never came to pass in 2008, and concerns about balance of payments problems and bank failures moved to Europe, instead. In the years following the crisis, EM debt enjoyed unprecedented growth as an asset class, even as investors' ability to rotate that debt has eroded. It will take future turmoil in the EM bond market for investors to learn what distortions current events have created, and to discover their consequences.
About the Author
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