Emerging market bonds hit as foreign investors dump debt

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Twenty years ago, a dangerous cocktail of debt accumulated in foreign money and deteriorating exchange rates led emerging markets into financial meltdown.

In the aftermath, countries vowed to repent of the “original sin” of borrowing huge sums in non-domestic currencies. Major emerging markets went from having more than three-quarters of their debt in foreign currencies to around half. Finance ministers were applauded for better protecting economies from swings in global market sentiment.
 
Yet as the world recoils from risky assets amid a slowdown in China and collapsing oil prices, emerging market bonds are once again being dragged into the fray.

Unable to resist strengthening currencies and double-digit yields at a time when returns in developed markets were falling, the share of local-market government debt owned by foreigners more than doubled between 2009 and 2015. Now they want out.


Funds invested in emerging market debt issued in domestic currencies have experienced five consecutive weeks of outflows, according to funds tracked by EPFR, taking net outflows over the past 12 months to $12bn.
 
The move means debt markets promoted as a means to insulate developing countries from sudden swings in international market sentiment are instead amplifying it.
 
For governments, the inflow of international capital was initially a blessing. Foreign money in local bond markets raises the profile of the country, suggesting international investors trust the government’s ability to manage its economy. Higher demand also boosts prices, reducing borrowing costs.

Foreign investors hold more than a quarter of the outstanding total of emerging market bonds issued in local currencies, up from 9 per cent a decade ago, according to the World Bank.

In Mexico, Indonesia, Poland and Peru, ownership of local currency debt markets by foreigners exceeds 35 per cent.

But as the share of international investors in domestic bond markets increased, the IMF began to point out that emerging markets should regard local currency debt held by foreigners in the same way as external debt, given the potential for foreign investors to sell their holdings.

Last year, that withdrawal began. Emerging markets suffered a net outflow of capital for the first time since the 1980s, according to the Institute of International Finance.
 
Currencies across emerging markets have plummeted. Brazil’s currency hit its lowest level against the dollar in two decades last year, while South Africa’s rand and the Russian rouble reached a record low earlier this year.

“It has been a disaster for local currency investors,” said Jim Barrineau, co-head of emerging markets debt at Schroders.



“The currency volatility means investors are unwilling to stomach these bonds. And as growth slows in the countries and the bond yields go higher, the cost of servicing debt is getting more difficult for the countries.”

Sergio Trigo Paz, co-manager of Blackrock’s emerging market flexible dynamic fund, one of the few in the sector to post a positive return last year, said the fund had slashed its exposure to local currency debt.

“Last year we saw there was no opportunity in going long in emerging market FX,” he said.

“So we use FX to decrease the volatility of the fund — as a hedging instrument. The first weeks of this year tell us something we were already worried about which is that we are entering a world without QE, and markets are now going to be far more volatile.”

As currencies fall and concerns about solvency grow, investors are demanding more to hold local currency bonds. Yields in 10-year Turkish lira bonds, for example, have increased over the past 12 months from 7.79 per cent to 10.52 per cent. Brazil’s benchmark 10-year cost of borrowing in real has jumped from 10.7 per cent one year ago to 16.02 per cent.
 
“There has been a noticeable increase in foreign ownership of local currency bonds in emerging markets and as they liquidate their holdings emerging market governments are left facing some unappetising choices,” said William Jackson, emerging markets economist at Capital Economics. “Do they intervene or not.

There are some exceptions. Emerging market borrowers close to Europe have benefited from the European Central Bank’s monetary easing and yields in debt issued by countries including Czech Republic and Latvia are falling.

The rest face a difficult choice between raising interest rates and implementing capital controls to keep foreign money in the country or allowing their currency to fall and accepting the risk of higher inflation.

“I don’t think we are facing an impending collapse in emerging markets,” says Neil Shearing, chief emerging markets economist at Capital Economics. “But I think there is a growing awareness that the damage being done right now means any recovery will be extremely fragile.”

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