The allure of emerging markets
Saturday, 11 August 2007
Joanna Chung in London
Since late last year, foreign investors have been stuffing themselves with kwacha.
Though it sounds like an exotic fruit, the kwacha is in fact the currency of Zambia, now seen by some investors as one of the more promising economies in Africa.
According to a report this month by the International Monetary Fund, foreign holdings of Zambian government securities - primarily by hedge funds - rose from a "negligible amount" to K540bn ($150m) during 2005, mostly in the last quarter. By May this year, that figure had risen to K840bn.
This influx has strengthened the currency and sent Zambian interest rates tumbling: bond yields have fallen by half from average levels of more than 20 per cent last year.
The sudden interest illustrates a broader theme in emerging markets over recent years: the constant hunt by bond investors for extra yield and their willingness to seek it in ever more far-flung locations.
Lately, the search has often led them to countries benefiting from the current commodities boom. Zambia, a major copper producer, is one example, though debt forgiveness and growing confidence in the country's macro-economic management have also helped it to attract foreign money.
Then there is the less exotic, disparate group sometimes known as the BRICs: Brazil, Russia, India and China. The four are very different, but their size gives them the shared potential to dominate the global economy in the decades to come.
Yet the story of the emerging markets is incomplete without mentioning the turmoil the asset class has endured in the past - and the fallout. Think Long Term Capital Management, the US hedge fund, which imploded in 1998 on the back of Russia's default.
As recently as May, investors got a sharp reminder of the risks when emerging markets experienced a sell-off. Investors took fright at apparently rising inflation and fears that central banks might raise interests too far, draining liquidity and curbing economic growth.
But Arnab Das, head of emerging markets research at Dresdner Kleinwort, saw the recent downturn as different from those in the past when "countries fell like dominoes". Instead, the reaction was more nuanced. "There is a lot of discrimination going on across countries," he says. "It is also important to distinguish between the different asset classes. Equities and currencies were the biggest hit during the sell-off, because that is where most of the aggressive risk-taking happened last year and during the first quarter of this year."
Sentiment seems to have turned positive again. Spreads, on emerging market bonds, as measured by JPMorgan's EMBI+ index, widened from a record low of 174bp over US Treasuries on May 3 to 238bp on June 27, sending prices correspondingly lower.
Spreads have since tightened again, and fell below 200bp earlier this week. Emerging market issuers are venturing back to the market. The Philippines this week sold about $750m of bonds while Uruguay, Panama and Argentina also launched deals.
"The love affair is back on," says Jim Croft, emerging markets trader at Commerzbank. "There may still be lingering concerns...but for now immediate evidence is of still excess cash in banking and the corporate sector, which is finding a home in [emerging market] assets."
It is not just the allure of yield. Bulls argue that many emerging economies are attractive investments. About half the outstanding bonds issued by emerging economies are now rated investment grade, up from about 30 per cent in 2001. In the past decade, many have built up foreign exchange reserves, strengthened their banking systems, and turned current account deficits into surplusses - helped by rising commodity prices.
Former financial basket-cases such as Mexico, Argentina, Brazil and Russia have bought back billions of dollars of bonds. Many issuers are increasingly choosing to issue local currency debt, further reducing their vulnerability to global economic shocks.
Philip Poole, head of emerging markets research at HSBC, said the recent downturn was a result of global tightening as opposed to any significant deterioration in fundamentals. "This was a one-time repricing of assets," he said.
Speculative investors such as hedge funds had been borrowing cheaply and investing in riskier but higher yielding assets in, for example, Turkey, Hungary, South Africa and Iceland - a strategy known as the carry trade. But the pressure of rising interest rates in the US, Europe and Japan sent investors on a selling spree.
Jerome Booth, head of research at Ashmore Investment Management, says: "A lot of tactical and speculative money left in May but that was mostly restricted to equities and those few currencies hit by the unwinding of the carry trade."
He points out that big pension funds are now investing in emerging market debt. "They used to allocate zero to emerging markets and now those pools of money are starting to look at emerging market debt very seriously."
Bouts of geopolitical upheaval such as the current crisis in the Middle East can easily stifle risk appetite. But for now, Mr Das of Dresdner says the market appears to have tolerance for risk. "That is not to say we are going into a new phase where people are going to buy risky assets like crazy...going forward, market participants are going to have to differentiate," he adds.
That suggests investors will need to rethink the definition of emerging markets, distinguishing between economies that have, to all intents and purposes, emerged, and those that are still works in progress.
Since late last year, foreign investors have been stuffing themselves with kwacha.
Though it sounds like an exotic fruit, the kwacha is in fact the currency of Zambia, now seen by some investors as one of the more promising economies in Africa.
According to a report this month by the International Monetary Fund, foreign holdings of Zambian government securities - primarily by hedge funds - rose from a "negligible amount" to K540bn ($150m) during 2005, mostly in the last quarter. By May this year, that figure had risen to K840bn.
This influx has strengthened the currency and sent Zambian interest rates tumbling: bond yields have fallen by half from average levels of more than 20 per cent last year.
The sudden interest illustrates a broader theme in emerging markets over recent years: the constant hunt by bond investors for extra yield and their willingness to seek it in ever more far-flung locations.
Lately, the search has often led them to countries benefiting from the current commodities boom. Zambia, a major copper producer, is one example, though debt forgiveness and growing confidence in the country's macro-economic management have also helped it to attract foreign money.
Then there is the less exotic, disparate group sometimes known as the BRICs: Brazil, Russia, India and China. The four are very different, but their size gives them the shared potential to dominate the global economy in the decades to come.
Yet the story of the emerging markets is incomplete without mentioning the turmoil the asset class has endured in the past - and the fallout. Think Long Term Capital Management, the US hedge fund, which imploded in 1998 on the back of Russia's default.
As recently as May, investors got a sharp reminder of the risks when emerging markets experienced a sell-off. Investors took fright at apparently rising inflation and fears that central banks might raise interests too far, draining liquidity and curbing economic growth.
But Arnab Das, head of emerging markets research at Dresdner Kleinwort, saw the recent downturn as different from those in the past when "countries fell like dominoes". Instead, the reaction was more nuanced. "There is a lot of discrimination going on across countries," he says. "It is also important to distinguish between the different asset classes. Equities and currencies were the biggest hit during the sell-off, because that is where most of the aggressive risk-taking happened last year and during the first quarter of this year."
Sentiment seems to have turned positive again. Spreads, on emerging market bonds, as measured by JPMorgan's EMBI+ index, widened from a record low of 174bp over US Treasuries on May 3 to 238bp on June 27, sending prices correspondingly lower.
Spreads have since tightened again, and fell below 200bp earlier this week. Emerging market issuers are venturing back to the market. The Philippines this week sold about $750m of bonds while Uruguay, Panama and Argentina also launched deals.
"The love affair is back on," says Jim Croft, emerging markets trader at Commerzbank. "There may still be lingering concerns...but for now immediate evidence is of still excess cash in banking and the corporate sector, which is finding a home in [emerging market] assets."
It is not just the allure of yield. Bulls argue that many emerging economies are attractive investments. About half the outstanding bonds issued by emerging economies are now rated investment grade, up from about 30 per cent in 2001. In the past decade, many have built up foreign exchange reserves, strengthened their banking systems, and turned current account deficits into surplusses - helped by rising commodity prices.
Former financial basket-cases such as Mexico, Argentina, Brazil and Russia have bought back billions of dollars of bonds. Many issuers are increasingly choosing to issue local currency debt, further reducing their vulnerability to global economic shocks.
Philip Poole, head of emerging markets research at HSBC, said the recent downturn was a result of global tightening as opposed to any significant deterioration in fundamentals. "This was a one-time repricing of assets," he said.
Speculative investors such as hedge funds had been borrowing cheaply and investing in riskier but higher yielding assets in, for example, Turkey, Hungary, South Africa and Iceland - a strategy known as the carry trade. But the pressure of rising interest rates in the US, Europe and Japan sent investors on a selling spree.
Jerome Booth, head of research at Ashmore Investment Management, says: "A lot of tactical and speculative money left in May but that was mostly restricted to equities and those few currencies hit by the unwinding of the carry trade."
He points out that big pension funds are now investing in emerging market debt. "They used to allocate zero to emerging markets and now those pools of money are starting to look at emerging market debt very seriously."
Bouts of geopolitical upheaval such as the current crisis in the Middle East can easily stifle risk appetite. But for now, Mr Das of Dresdner says the market appears to have tolerance for risk. "That is not to say we are going into a new phase where people are going to buy risky assets like crazy...going forward, market participants are going to have to differentiate," he adds.
That suggests investors will need to rethink the definition of emerging markets, distinguishing between economies that have, to all intents and purposes, emerged, and those that are still works in progress.