Global Investing

Happy birthday EMBI! The index group, the main benchmark for emerging market bond investors, turns 20 this year.  When officially launched on Dec 31 1993, the world was a different place. The Mexican, Asian and Russian financial crises were still ahead, as was Argentina’s $100 billion debt default. The euro zone didn’t exist, let alone its debt crisis. Emerging debt was something only the most reckless investors dabbled in.

To mark the upcoming anniversary, JPMorgan – the owner of the indices – has published some interesting data that shows how the asset class has been transformed in the past two decades.  In 1993:
- The emerging debt universe was worth just $422 billion, the EMBI Global had 14 sovereign bonds in it with a market capitalisation of $112 billion.
- The average credit rating on the index was BB.
- Public debt-to-GDP was almost 100 percent back then for emerging markets, compared to 69 percent for developed markets.
- Forex reserves for EMBI countries stood at $116 billion
- Per capita annual GDP for index countries was less than $3000.
Now fast forward 20 years:
- The emerging debt universe is close to $10 trillion, there are 55 countries in the EMBIG index and the market capitalisation of the three main JPM indices has swollen to $2.7 trillion.
- The EMBIG has an average Baa3 credit rating (investment grade) with 62 percent of its market cap investment-grade rated.
- Public debt is now 34 percent of GDP on average in emerging markets, while developed world debt ratios have ballooned to 119 percent of GDP.
- Forex reserves for EMBIG members stand at $6.1 trillion
- Per capita annual income has risen 2.5 times to $7,373.

What next? The thinking at JPM seems to be that the day is not far off when a country “graduates” from the EMBI and joins the developed world.  To be excluded from the EMBI group of indices, a country’s gross national income must exceed the bank’s “index income ceiling” (calculated using World Bank methodology) for three years in a row or have a sovereign credit rating of A3/A- for three consecutive years.

Could Asia be headed for a debt crisis?

The very thought may seem ludicrous given the region’s mighty current account surpluses and brimming central bank coffers.  But a note from RBS analysts Drew Brick and Rob Ryan raises some interesting concerns.

Historically speaking, most EM crises have been borne on the back of excessive capital inflows, Brick and Ryan write. And in many Asian countries, the consequence of these flows has been over-easy monetary policy that has left citizens and companies addicted to cheap money. Personal and corporate indebtedness levels have spiralled even higher in the past five years as governments across the continent responded to the 2008 credit crunch by unleashing billions of dollars in stimulus.

First, some numbers and graphics:

a) Asia’s current account surplus stands now around $250 billion, less than half its 2007 peak as exports have slumped.

Central bankers as carry traders? Why not.

As we wrote here yesterday, FX reserves at global central banks may be starting to rise again. That’s a consequence of a pick up in portfolio investment flows in recent weeks and is likely to continue after the U.S. Fed’s announcement of its QE3 money-printing programme.

According to analysts at ING, the Fed’s decision to restart its printing presses will first of all increase liquidity (some of which will find its way into central bank coffers). Second, it also tends to depress volatility and lower volatility encourages the carry trade. Over the next 12 months these  two themes will combine as global reserve managers twin their efforts to keep their money safe and still try to make a return, ING predicts, dubbing it a positive carry story.

The first problem is that yields are abysmal on traditional reserve currencies. That means any reserve managers keen to boost returns will try to diversify from the  dollar, euro, sterling and yen that constitute 90 percent of global reserves. Back in the spring of 2009 when the Fed scaled up QE1, its move depressed the dollar and drove reserve managers towards the euro, which was the most liquid alternative at the time. ING writes:

One of the big stories of the past decade, that of staggering reserve accummulation by emerging market central banks, appeared to have ground to a halt as global trade and economic growth slumped. But according to Bank of America/Merrill Lynch, reserves are  starting to grow again for the first time since mid-2011.

The bank calculates that reserve accumulation by the top-50 emerging central banks should top $108 billion in September after strong inflows of around $13 billion in each of the first  two weeks. Look at the graphic below.

So what is the source of these inflows? As BoA/ML points out global trade balances are at their cyclical lows and that is reflected in the dwindling current account surpluses in the developing world. But as risk sentiment has improved in the past six weeks,  there has been a pick up in fixed income and equity investment flows to emerging markets, compared to the developed world.

Lucky Australia. In a world of slowing economic growth its central bank today raised forecasts for 2012 GDP growth by a half point to 3.5 percent. That’s down to a mining boom, driven of course by China. But there’s a downside. Australia’s currency, the dollar (or affectionately, the Aussie), has steadily risen in recent years, and is up 3 percent versus the U.S. dollar this year. Unsurprisingly, the Reserve Bank of Australia tempered its good news on growth with a warning over the Aussie’s gains.

Analysts at Credit Agricole note that the Aussie’s gains this year have come in tandem with a rise in Japan’s yen. That in itself would have been highly unusual in the past: the yen is a so-called safe haven, the currency investors run to when all else is selling off, while the Aussie is a commodity currency, one that does well when world growth is looking good and risk appetite is high. CA analysts explain thus:

The role of the (Aussie) is probably changing from a traditional commodity currency to an increasingly attractive reserve currency.

The Indian rupee’s plunge this week to record lows will have surprised no one. After all, the currency has been inching towards this for weeks, propelled by the government’s paralysis on vital reforms and tax wrangles with big foreign investors. These are leading to a drying up of FDI and accelerating the exodus from stock markets. Industrial production and exports have been falling.  High oil prices have added a nasty twist to that cocktail. If the euro zone noise gets louder, a balance of payments crisis may loom. The rupee could fall further to 56 per dollar, most analysts predict.

True, the rupee is not the only emerging currency that is taking a hit. But the Reserve Bank of India looks especially powerless to stem the decline. (See here for an article by my colleagues in Mumbai) .  One reason  the RBI’s hands are  effectively tied is that  India is one of the few emerging economies that has failed to build up its hard currency reserves since the 2008 crisis and so is unable to spend in the currency’s defence. Usable FX reserves stand now around $260 bilion, down from $300 billion just before the 2008 crisis.  See the following graphic from UBS which shows that relative to GDP, India’s reserve loss has been the greatest in emerging markets.

But there is worse. The relative decline in reserves since 2008 coincides with a ballooning in India’s external debt, both private and public. Comprising mostly of corporate borrowing and trade credit, the debt stands at $350  billion, up from $225 billion four years back.

Japan has not been a sexy destination for investment. In an environment of rising sovereign risk, Japan’s huge debt burden (+200% and rising) and lack of triple-A rating (Japan is rated AA-, Aa3 and AA by the main rating agencies) are not something that would attract the world’s investors, including the powerful central bank reserve managers.

However, the yen is a different story. Enjoying a safe-haven status, the Japanese currency is staying just below its all-time high around 75.90 per dollar, while it also rose to an 11-year peak against the euro in January.

JP Morgan,whose asset management arm manages $70 billion for 65 official sector clients including central banks and sovereign wealth funds, says reserve managers have been diversifying into non-G4 currencies but the strategy has not performed well.

Five things to think about this week:

HOLDING UP — FOR NOW 
- A good run in equities has so far been helped rather than hindered by U.S. company results. Some are questioning how long the upward momentum can be sustained given cost-cutting rather than improved revenue streams flattered profit margins. The European earnings season, which cranks up a gear this week, and the release of U.S. Q2 GDP data could be potential triggers for a pullback, but the sensitivity to bad news may depend on how much money is chasing the latest push higher. 
    

EARNINGS 
- European earnings flooding out in the coming weeks may paint a less rosy picture of the banking sector than seen on the other side of the Atlantic. While investment and trading activities should be supportive, bad loan provisions will be particularly closely scrutinised, as will the central and eastern Europe exposure of the likes of Erste. The supply/demand outlook for key commodities plans will also be in the limelight given the battery of oil and chemical firms reporting in Europe and the U.S. 

CORRELATIONS 
- There are signs of some breakdown in the lockstep moves that financial markets had become accustomed to seeing in FX/stocks or stocks/bonds. Calyon research shows correlation between the bank’s proprietary risk aversion barometer and exchange rates has been less robust in the past month. While this correlation nevertheless remains stronger than that between FX and interest rate differentials, the markets’ thoughts are turning to new linkages that might prove better trading guides.