The prevailing wisdom in the finance world is that in times of economic uncertainty, investments in developed markets tend to be more resilient than those in emerging economies. However, the recent global financial crisis was triggered in developed countries and has caused those economies to experience unprecedented fiscal deterioration and capital-market drawdowns. Companies and consumers in the developed world were forced to unwind leverage that was many times greater than that which was held by their relatively debt-free counterparts in the developing world.
To fight the deflationary spiral that was expected to grip the economies of the U.S., Europe, and Japan, governments in these countries were compelled to enact debt-financed fiscal-stimulus packages. These were typified by the $841.2 billion plan in the U.S. and the more than $270 billion of collective spending by EU nations. A similar program in China injected $204.3 billion into the rapidly expanding economy. By comparison, most developing countries enacted substantially smaller programs. For example, India adopted a $6.5 billion spending plan while Brazil’s totaled $3.6 billion. It is worth noting that the stimulus program in the U.S. was an estimated 6% of GDP, while similar plans by Brazil and India each represented 0.5% of GDP. Such large spending plans led to an increase in developed countries’ debt. By the beginning of 2012, the overall levels of government debt were expected to be three times higher in developed economies than they were in emerging markets.
As the levels of debt shifted, investors view of the debt markets in emerging countries grew more positive. These markets are now often seen as less volatile and more attractive despite countries’ dramatically weaker history of social, political, and economic stability. The lower debt burden and faster growing economies offer a more compelling risk-return profile. As a result, investors are increasingly looking to gain exposure to these debt markets through emerging-market credit and debt funds.
Investors can take advantage of the emerging-market debt market through three strategies: sovereign hard-currency debt, local currency debt, and corporate debt. Emerging-market debt has generally been accessible through hard currency strategies, given concerns over the instability of local currencies and inflation. Globally traded currencies from countries with a history of stability and backed by strong economies, military forces, and fiscally responsible governments are often referred to as hard currencies. Currently, the U.S. dollar, Japanese yen, and the EU’s euro are the world’s three preeminent hard currencies.
Over the course of the last decade, the stabilization of local currencies in developing nations has contrasted with the protracted deterioration in the value of the U.S. dollar and the Central Bank-driven volatility of the yen and the euro. Thanks to their proven credit worthiness, emerging-market local currency debt strategies emerged and are one of the most popular strategies in the space.
There has been a substantial increase over the past ten years in the size and diversity of the local currency debt market, and this trend should persist. As emerging nations continue to expand and move into the next stage of development, their fiscal needs will become larger and more sophisticated, and they will turn to the global debt markets to finance their increasingly complex needs.
In addition to sovereign hard-currency debt and local currency debt, investors can diversify their portfolios to include emerging-market corporate debt. Corporate debt used to be a space exclusively reserved for developed markets. Emerging-market corporations were more likely to tap traditional loans, often from the government and affiliated institutions. Additionally, the rapid and uninterrupted revenue growth of businesses in emerging markets made the issuance of bonds unattractive when compared with using retained earnings to finance operations and growth. However, thanks to new debt-financed efforts to expand globally, the detrimental effects of the slowdown in world trade, and the increase in the size of M&A transaction in these areas, emerging-market corporate debt has grown from $20 billion in annual issuance in 2002 to about $400 billion as of the end of January 2012.
Even as many emerging-market countries are experiencing slowing growth, debt issued by these nations is expected to remain a strong and resilient strategy that investors are increasingly looking to add to their portfolios. The strategy offers a rare combination of excellent return potential, stability, and diversification away from U.S. dollar and euro assets that often make up a substantial portion of investors’ portfolios.