If there is a picture that encapsulates the crisis in emerging markets, it is that of protestors jumping into the swimming pool of deposed Sri Lankan president Gotabaya Rajapaksa. But the joyful scenes mask a grim reality for many Sri Lankans. The government’s mismanagement of the country has accelerated the effects of a global debt crisis that have plunged the country into poverty. More than 10% of country’s 22 million people are living below the poverty line. The United Nations estimates that food shortages mean 70% of the population miss at least one meal a day and one in five are hungry. Pushed to the brink, Sri Lanka defaulted on $35bn (£28bn) of its foreign debt and is holding restructuring talks with China and its other major creditors.
What does all this mean for UK institutional investors who hold emerging market debt? In the first instance, it drives home the human costs of sovereign debt crises. But there is also an argument to be made that Sri Lanka may well be the canary in the coal mine for a gulf of defaults across emerging nations. Rising commodity prices, inflation and rate hikes have created a vicious cocktail that for many countries may well be too hard to stomach. In the first half of this year, emerging markets bond funds faced $50bn (£41bn) in outflows, according to JP Morgan.
Does this mean that investors should simply ditch their holdings? That may be premature, given that emerging markets account for more than half of global GDP, but only a fraction of global investment. In the UK, 37% of defined benefit (DB) schemes are invested in emerging market debt, with an average allocation of 4%, according to Mercer. Among defined contribution (DC) schemes, 30% are exposed to the asset class, which, on average, accounts for 7% of the portfolio.
But given the still relatively low yields in developed markets, the share of emerging markets in pension funds is growing. DB schemes, for example, have increased their allocation by 9% year-on-year and it also accounts for a growing share of DC schemes’ fixed income portfolios, according to Mercer. But with risks mounting, how can investors navigate the coming storm?
Dollar trouble
How did we get here? One factor that helps explain the growing share of low-and middle-income countries in international debt markets is ultra-loose monetary policy across developed nations, which has pushed interest rates down globally.
As a result, the volume of emerging market debt in circulation has doubled to $9.3trn (£7.7trn) from $5trn (£4trn) in 10 years, according to the World Bank. Covid has again accelerated this trend, with the debt stock of emerging markets rising by almost 7% in 2021 alone.
And paying back the rising debt mountain has become a lot more expensive, especially for hard currency debt, which tends to be dollar denominated. The price of the dollar has reached a 20-year high (as of June 2022), pushing up the costs of servicing this debt.
For many investors, this brings back bad memories of the 2013 taper tantrum, when speculation of a Fed rate hike caused a stampede out of emerging markets. The rising dollar has also caused fund managers to ring the alarm bells. US asset manager Man Group has warned that around 10% of dollar-denominated debt is at risk of default. A record 19 emerging market countries are trading at distressed levels, which amounts to $237bn (£196bn) in debt, according to Bloomberg.
Staying local
While all this is deeply alarming, there is, however, an important counteracting factor, as Stuart Trow, a columnist and former credit strategist at the European Bank for Reconstruction and Development explains: the share of local currency debt has been increasing. It now accounts for almost all outstanding emerging market borrowings.
As of 2018, local currency debt stood at just above $2.2trn (£1.8trn), compared to around $880bn (£729bn) in hard currency, according to JP Morgan. This marks a significant change compared to the situation during the taper tantrum in 2013, when hard currency debt was more prominent.
But local currency debt is highly concentrated among the biggest issuers. For more than 80 emerging countries, hard currency debt remains dominant because investors do not have faith in the stability of their currency. These countries remain exposed to the risks of the rising dollar. “From an investor perspective, there is now a lot more interest in local currency debt, but when you look at the market, a lot of the big issuers, such as Turkey and Russia, have disappeared and China has become less attractive as a local currency investment,” Trow says.
“For international investors, the whole point of local currency debt is to wean people off exposure to the dollar,” he adds. “Clearly that is playing a role now. Nobody can completely escape the dollar but it would be worse if they didn’t have local currency debt.”
It is no wonder then, that international creditor bodies, such as the IMF, aim to promote the development of local currency debt markets as an important source of financial resilience.
But local currency debt is by no means a panacea, warns Dinesh Visavadia, a director at Independent Trustee Services. “From a trustee point of view, there is the challenge to consider whether you invest in hard or local currency debt and, of course, hard currency can be more reasonable because you will
have more due diligence and governance. With local currency debt, you are always subject to fluctuations in the country’s currency,” he says.
“A lot of trustees will be uncomfortable with the level of volatility in local currency debt,” Visavadia adds, acknowledging that this means they would have to weigh currency stability versus heightened default risks in hard currency debt.
The China factor
Another factor to consider when investing in emerging markets is the role of China, which thwarts the overall trend. China represents a third of the of MSCI Emerging Market index and is a much more dominant force than it was nine years ago, just prior to the taper tantrum. Back then, China accounted for 18%
of the index and the index was, generally speaking, more diversified. But now China accounts for more than half of all debt outstanding, owing $2.7trn (£2.2trn) of the $9.3trn (£7.7trn) emerging market debt pile. Chinese borrowing increased 14.4% last year, according to the World Bank. Excluding China,
emerging market debt only rose 1.9%.
So increasingly, there is an argument to be made that China should be excluded from emerging market debt indices and treated as an entity on its own. As the world’s biggest importer of commodities and given its high debt levels, China was also at the forefront of emerging market outflows. In July alone, €3bn (£2.5bn) of the country’s debt was dumped, according to the Institute for International Finance.
Consequently, China has turned from investor’s favourite to an investor’s foe. This is accelerated by rising commodity prices, where China is effectively importing inflation.
Asset managers have responded to this trend by increasingly offering emerging market debt strategies that exclude China. Examples include BlackRock, Amundi, Eastspring, GMO, DFA Investment and Baillie Gifford, which have all launched ex-China strategies, according to Blomberg.
This does not yet resonate with UK investors. Only 15% of British final salary schemes are considering a separate China allocation in their emerging market strategy, according to Mercer’s asset allocation survey, which was, however, conducted in 2021.
However, simply ditching China from emerging market strategies opens the door to another problem, that of a rapidly shrinking emerging market universe. With Russia having been booted out of most benchmark indices and Turkey facing skyrocketing inflation (79% at the time of writing), the investable universe has now become quite a bit smaller than it was at the beginning of this year.
Navigating the storm
Given the uncertain outlook for a rapidly changing emerging market landscape, how should investors access the asset class? Visavadia says that there is still a lot of opportunity, given that some of the default risks have been priced in, but warns that investors should access emerging markets selectively.
Visavadia sees the growing importance of ESG investing as a challenge and an opportunity for emerging markets. “Countries and companies are going on a journey in terms of ESG credibility. There is also a risk here that many may not meet the ESG criteria that international investors are setting and this could add to higher default rates in emerging markets,” he says.
In terms of regions, Visavadia is particularly upbeat about Africa and any countries that are exporting commodities. While they have struggled historically from falling commodity prices, they could now benefit from rising commodity prices, he says.
This ties into an argument that Trow is making. Net exporting countries, those with favourable balance of payments, could be relatively more resilient to the impact of the rising dollar and rising energy prices. While oil exporters, such as the Gulf States, stand to benefit in the short run, in the long run countries that are able to contribute to the transition towards renewable energy could become some of the key beneficiaries.
And there are good examples of pension funds banking in on this trend. Earlier this year, a collaboration between 12 UK pension funds, led by The Church of England’s Pensions Board, was announced, which aims to fund the climate transition in emerging markets. This includes USS, BT Pension Fund, Railpen, Brunel Pension Partnership, Border to Coast Pension Partnership, Nest and Legal & General Workplace Pension Plan, which collectively manage more than £400bn in assets. They will join forces to invest in the energy transition across emerging markets.
An indication that the way UK institutional investors are accessing the asset class is rapidly changing.
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