Emerging markets in an era of debt

September 28, 2010

–  Robert O. Abad is a senior research analyst and Matt Graves is an analyst for Western Asset.  The views expressed are their own. –

The landscape of global debt markets has changed drastically since the problems in Greece first arose earlier this year. Markets have been incredibly resilient in the face of sovereign-related problems, but the change in collective market psychology—in which a transition was made from an obsessive focus on the growth drivers of a global economic recovery to a careful consideration of the risks posed by the mounting stock of developed world public debt—has been the single most important driver of volatility this year.

From the vantage point of emerging markets, the pattern of events in the years leading up to the 2008 financial crisis offer a clear and disturbing parallel to the lesser developed countries’ (LDC) debt crisis of the early 1980s.  Global liquidity conditions fueled a debt-driven growth story in Latin America that ended with the region crumbling under the weight of massive debt and the US financial system facing potential insolvency.

However, understanding the current environment in the context of the LDC’s debt crisis is critical not for what it tells us of the unfolding of financial collapse (we now have our own version of that history), but for what it tells us of the years that follow such a collapse.  Following 10 years of hardship, banks and governments formally—and finally—recognized that these countries could not fully service their debts and simultaneously restore growth. The result was a “lost decade,” characterized by negative growth and with wrenching effects on societies and governments.

As the US turned in quarter-over-quarter annualized growth of 5% to close out 2009, the prospects of our own lost decade may have seemed remote.  Indeed, the stimulus packages engineered by governments worldwide started exerting a positive influence on economic data beginning in 2009, and as these effects stretched into 2010, optimism grew that a sustained recovery may well have been underway. However, with the gradual rollback of stimulus measures, the strength and sustainability of the recovery has, once again, become a topic of serious debate.

In contrast, emerging markets remain a notable bright spot in the global recovery story. With record levels of foreign exchange reserves, improved public and external debt ratios, greater policy flexibility and transparency, and continued access to external capital markets, many emerging markets are well positioned to take advantage of the shifting economic landscape of a post-crisis world—a direct result of reforms and structural change these nations have pursued over the last decade.

Considering the years of turmoil and foregone economic progress endured as these lessons were learned, the turnaround in emerging markets is nothing short of spectacular.

However, despite the meaningful progress made in many emerging economies, a potential scenario of slower global growth—for example, as a result of a financial retrenchment in the developed world—would undoubtedly have widespread and lasting effects. The additional fiscal cost and financial market volatility associated with new and potentially larger emergency response measures to a deeper and wider debt crisis would reverberate negatively on strained sovereign balance sheets worldwide.

Going forward, we should expect the oft-ignored term “debt sustainability” to grow in significance, taking a place alongside the traditional growth and inflation metrics in the arsenal of economic tools.  Debt sustainability is a function of the real rate of growth, the primary balance, the real interest rate and the stock of debt-to-GDP.

In a scenario of lower growth, the flexibility to address a sovereign’s indebtedness through channels other than growth will be critical. Worsening fiscal deficits without credible strategies to address long-term debt reduction, for example, will increase perceptions of sovereign risk.  This can result in a negative feedback loop wherein higher interest rates impede the stabilization of debt ratios and, worse, increase the likelihood of extreme, negative outcomes.

Having further strengthened their balance sheets over the past year by refinancing existing debt at lower rates for longer maturities, and in some cases in their own domestic currency, most emerging economies are less susceptible to such a fragile debt sustainability dynamic than they have been in years past.

As such, and in a break with the past, the thesis for investing in emerging markets should not focus upon the historical emphasis on higher rates of expected growth in emerging markets vis-a-vis the developed world.

Rather, in a market characterized by uncertainty and concern over rising sovereign debt risk, the more compelling rationale for investing in emerging markets today centers on the improved debt sustainability metrics these nations now enjoy. Indeed, it is the greater degree of financial flexibility in emerging markets that will enable many of these countries to weather additional market volatility in a scenario of slowing global growth, and to rebound sharply when global conditions ultimately do turn around.

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