A tip of the top hat to the excellent Sid Verma of FT Tilt, who sends us to a recent paper by PineBridge Investments analysing the state of emerging market debt as an asset class.
Consistent readers will remember that we’ve been trying to keep a watchful eye on the capital flows story, which we think has generated too much heat and not enough light. At issue is to what extent these flows are now driven by impatient hot money versus the post-crisis resumption of a secular trend.
We’re not sure, but we suspect the latter is more responsible than many people think. Keeping in mind our vulnerability to confirmation bias, the PineBridge paper seems to reinforce this — at least with respect to debt markets (check out another Sid post for the potentially more worrisome trend in EM equities):
Overall, investors tend to allocate most heavily to local currency debt markets. Between January and October 2010, the figure was close to 60%, US $35bn was allocated to local currency, with US $26bn into external debt4. In addition to traditional EM investment managers and cross-over investors, two new investor types – foreign exchange (FX) overlay funds and EM bond ETFs totaling around US $4-5bn in size – have helped drive demand for EM bonds. (Figures 1 & 2)
Despite these massive inflows, we are not seeing signs that emerging markets are in a bubble. First, fundamentals are positive: more sustainable debt dynamics and stronger institutions support the view that the EMD asset class is not as vulnerable as it used to be.
Secondly, the participation of foreign investors in the local debt of these markets is modest. On average, foreign investors own about 25% of local market cap, ranging from around 30% in Indonesia, the Philippines, Mexico and EMEA, to 10% or less in the remaining EM countries. This is despite a substantial recovery in the markets from the lows of the 2008 financial crisis, when it dropped to the low teens.
Thirdly, banking sector indicators reveal solid numbers, consistent with the pace of the recent recovery. Private credit growth is at, or below, 10% year on year in the majority of EM countries and, with the exception of some Baltic and CIS countries, non-performing loans are typically below 5%.5 Though we have already seen positive growth in EMD, these are strong signs that the asset class still has plenty of room to expand before we see any sign of a slowdown.
All sounds very sensible, though this part is less inspiring:
So long as policy mistakes can be avoided, either at the central bank or government level, i.e., inflation is kept under control and the fiscal outlook is positive, we believe there is no reason to be concerned.
That’s awfully burdensome for a “so long as” — and it’s a lot like saying that there’s no reason to be concerned until there’s a reason to be concerned.
The ongoing development of EM debt markets is, of course, something of a mixed bag: it’s useful for correcting global imbalances while also, if not done carefully, setting the stage for a potential financial crisis later on.
Related links:
Hitchhiker’s guide to the EM debt galaxy – FT Tilt
IMF: QE2 is not overheating the EMs – FT Alphaville
Uncertainty and capital controls – FT Alphaville
A G20 “victory” – FT Alphaville
Of bond markets and imbalances – FT Alphaville