EM INVESTMENT: Show of hands
(EM) Emerging nations are talking big about investing in each others’ currencies. But diversifying reserves out of traditional assets will not be so easy.
This June, China took another step towards the internationalization of the renminbi. It agreed to a local currency swap of 60 billion reais ($30 billion) with Brazil, to be used to boost bilateral trade, or to build up reserves in times of difficulty. “It is a measure that reinforces the economies of both countries,” Guido Mantega, Brazil’s finance minister, said at the time. By then, China had already signed 20 such agreements with countries as diverse as Argentina and the United Arab Emirates.
The agreement was followed by further announcements at the G20 meeting in Los Cabos in Mexico. The so-called Brics (Brazil, Russia, India, China, South Africa) countries said that they would establish more local currency swap agreements among themselves, and that they would begin to establish a financial safety net, creating a joint pool of reserves to mitigate against risk.
The decision surprised no one, and it is easy to understand why.
The developed world is struggling, and will continue to languish for the forseeable future. Emerging markets are faring far better in terms of growth, although fears of a slowdown run high. According to Eshwar Prasad, a senior professor at Cornell University, the aggregate debt of advanced economies increased from $18,100 billion in 2007 to $29,500 billion in 2011, and is expected to rise to $41,300 billion in 2016. The corresponding numbers for emerging market economies are $3,800 billion, $4,900 billion and $6,700 billion, respectively.
The IMF has said that the US will need to cut its structural deficit by 17.5% of GDP to return the country to a pre-crisis debt level of 60% of GDP by 2030. Japan will need to cut it by 14%, and the UK will need a 13.5% reduction.
This means, according to analysts, that both issuance of emerging market bonds and investment in them are likely to increase. Sebastien Barbe, head of emerging markets research and strategy at Credit Agricole, says that developing economies have small corporate and government bond markets.
“The potential for local bond markets is very high,” he says. Big opportunities will come from the fact that these countries will have to upgrade their infrastructure, and private consumption will increase as their economies grow. For example, Barbe says, in India there are 30 cars for every 1,000 people compared with 500 cars for 1,000 people in western Europe.
Andrew Dell, HSBC Africa chief executive, says emerging countries’ debt has had a “phenomenal run” lately and is becoming “a key asset class”. This is because the rest of the world has become riskier over the past four years so the risk in developing markets seems relatively less; moreover, political conditions in some emerging countries have stabilized, making them attractive to investors. Also, there is “massive, massive global liquidity around in the absence of significant inflation,” Dell says.
Like Barbe, he sees additional potential for growth in the fact that there are “huge amounts of infrastructure” to be built by fast-growing economies.
The dollar has lost 25% of its nominal value since 2002. Despite this, in its April 2012 report, The allure of emerging Asia for reserve managers, the Royal Bank of Scotland argues that the dollar is still overvalued by about 30%.
For central banks in emerging markets, all of this presents a challenge. Emerging markets now hold the bulk of global foreign exchange reserves, having learnt lessons from the Asian financial crisis of 1997 and the Russian debt crisis of 1998.
According to RBS, global foreign exch-ange reserves amounted to $800 billion in 1990, with mature markets accounting for 80% of this. By 2000, reserves had more or less doubled. Mature economies still accounted for more than half. However, by September 2011, global foreign exchange reserves had increased more than 10-fold, reaching $9 trillion. Emerging markets accounted for 68%.
The bulk of these reserves are invested in the dollar, followed by the euro and yen, mainly in US Treasuries, German Bunds and Japanese government debt.
Through this, developing countries subsidize developed countries’ growth to some extent, Simon Quijano-Evans, chief economist and head of research for EMEA at ING, says. “[Emerging markets] know full well that if they wouldn’t be buying Treasuries, they wouldn’t be supporting the US economy,” he says. When China buys US debt, it is “cross-subsidizing growth”, and this is “something not many people talk about”, Quijano-Evans adds.
He sees the convergence between developed and developing countries’ debt spreads continuing, as investors are more and more aware of the increasing risks in advanced economies – something other analysts say is slowly dawning on policymakers.
“It is becoming increasingly obvious to central bankers that the dominance of the US dollar in central banks is unsustainable,” says Jerome Booth, head of research at emerging markets specialist manager Ashmore.
The IMF puts together a currency composition of official foreign exchange reserves, based on data from countries that provide it with information (which account for a little over half of global currency reserves). Within this sample, dollar-denominated reserves are heavily concentrated, making up 61.9% of the total at the end of the third quarter of 2011, according to RBS.
But this figure has fallen from 65.7% at the end of 2007, suggesting that central banks are diversifying out of traditional currency reserves, albeit slowly.
“Many of these countries have accumulated so much in terms of FX reserves that they can allow to allocate a portion for clear investment objectives. Also US Treasury yields have collapsed, and investors have come to the realization that the bond markets in some of these rich countries are not devoid of risk,” says Alexander Kozhemiakin, director of emerging market strategies and senior portfolio manager at Standish Mellon Asset Management.
Standish manages $12 billion in emerging market debt. Five years ago, the firm had only one sovereign client that was invested with it. Now, it has almost a dozen central bank and sovereign wealth fund clients, with approximately 60% of them from emerging markets.
This trend is likely to pick up, according to Quijano-Evans, who says that, with such high debt-to-GDP ratios in the developed world, “there’s no way governments will stand by and watch pension funds get zero returns; they will invest in emerging markets.”
Michael Ganske, managing director and head of emerging markets research at Commerzbank, believes that the mutualization of debt in the eurozone would dilute Germany’s credit quality. Clients in emerging markets are changing their attitude and are beginning to move away from Treasuries and Bunds, he says, but are approaching it with caution as “the asset class is not homogenous.”
CHALLENGES
For central banks and other sovereign entities, divesting assets can be problematic. Liquidity, for example, is a major concern. “The problem is that emerging market currencies don’t often have the same liquidity [as the dollar]. If everybody started to make a 10% allocation to Brazilian reais, it would be overrun in terms of demand from those investors,” Kozhemiakin says.
According to the 2010 Triennial central bank survey on global foreign exchange activity by the Bank of International Settlements, the spot turnover for the dollar was $1,200 billion a day. The euro was $700 billion, and the yen was $300 billion a day.
By contrast, the spot turnover for all emerging Asian currencies listed in the survey was $91 billion a day, for emerging Europe it was $39 billion, and for Latin American currencies it was $27 billion.
“In a severe period of market stress, it would be easier to sell US T-bills than most other assets,” says Javier Corominas, head of economic research and FX strategy at Record Currency Management. He also points out that the objective of central banks is not to maximize return. “Profit is not at the heart of central bank FX reserve management,” he says. “Holding significant amounts of liquid, highly rated securities to act as buffer in times of crisis is closer to the mark.”
But Ashmore’s Booth disagrees. “Economists know that the biggest risk by far to central banks is the US dollars that they hold in reserves. But there is a consensus that one of the principal priorities is to have liquidity,” he says. “The problem is that holding liquidity is absolutely impossible. Central banks are so large today that one single treasury, and one single market, cannot provide the liquidity for all the reserves in a crisis.
“Liquidity can change very suddenly and always negatively. The vast bulk of US Treasuries traded outside the US are held by emerging market central banks. If the Chinese or the Russians start selling, frankly, who on earth is going to be on the other side of that trade?”
Booth argues that economists and market practitioners are “in denial”. “If 5% of emerging market bank reserves moved into emerging market currencies in five years, then there would be a lot more stability, particularly if we get shocks from the deleveraging process of the economies of the north.”
Two other problems, Barbe says, are the fact that many emerging assets are still rated below investment grade – with some central banks being forced by law to invest only in the safest-rated assets – and there is also the lack of knowledge within developing countries of other economies in the emerging world. “[Policymakers] want to make sure they understand it; they are building up their knowledge.”
The ratings differential is unfair for some emerging markets, Quijano-Evans believes. “Why is Turkey eight notches below
Belgium? It is politically very stable, it should be investment grade,” he says.
MACRO ENVIRONMENT
But do emerging markets even want their own currencies to be bought? “Don’t forget that a lot of emerging market countries have been fighting portfolio inflows. They want to keep their currencies weak, so they haven’t wanted other countries or investors to buy their currencies,” says Julian Adams, chief investment officer of Adelante Asset Management.
There are political considerations as well. “This is a very economically and politically sensitive issue. Back in 2007 and 2008, when the China Investment Corporation was making investments into companies like Blackstone, and these things lost a lot of value very quickly, there was a lot of criticism,” says Dawid Krige, managing director of Cederberg Capital, which launched its Greater China Equity Fund at the beginning of this year.
It means that decision-makers are wary of moving away from traditional bonds, which are still, despite recent events, perceived as being safe. In fact, in May the euro lost nearly 7% against the dollar, over fears of a Greek exit. Currency traders were reported to have said that central banks were the biggest sellers of the euro. But dollars benefited as a result.
“The reason that the Chinese would have bought T-bills is not because they like T-bills. It is because they want to buy dollars, and they have to put it in something, and typically T-bills and bonds are seen to be the lowest risk,” says Mouhammed Choukeir, chief investment officer of Kleinwort Benson. “They aren’t going to buy US equities or corporate bonds.”
Even though they are not buying each other’s debt in massive amounts, emerging markets are finding other ways to invest in themselves. “Historically China has mostly traded with the developed world, with the US and Europe in particular.
This is changing quite rapidly,” says Cederberg Capital’s Krige.
“China has been diversifying with its trade partners. It has been buying assets in many parts of the world, particularly buying commodities. It is trying to secure food supplies in farmland in Africa and elsewhere. So its foreign exchange reserves have portfolios in US Treasuries, but it also has hard assets on the agenda, and that is going to mean trade with non-developed markets.”
Adams also points to China’s lending-for-consumption model. “The Chinese tend to lend countries money to buy their products. They are unique in their business model. They will say, ‘OK, we want to buy your iron ore, so we will fund the expansion of your railway system, which will speed up the transportation of your iron ore,’” he says.
One recent example would be China’s loan of $1 billion to Nigeria to part finance a 98-mile railway between Lagos, the commercial capital, and Ibadan, Nigeria’s third-largest city.
In fact, all roads lead to China. Where China leads, the other large emerging market players will follow, say analysts. “They are aware that they have an enormous risk from their concentration of heavily indebted developed country sovereign bonds. But the rest of the Brics are waiting for China. The Chinese would prefer to move slowly, and gradually take the lead,” says Booth.
Until China finds significant opportunities to invest in non-convertible currencies from other developing nations, and overcomes political and economic sensitivities, change will be slow. But the trend of switching from advanced economies’ assets to emerging markets at least partially is here to stay – and it deserves more attention.
“Over the past four years, we have been busy trying to figure out what the ‘new normal’ means for developed markets. Maybe we should focus on what the ‘new normal’ means for emerging markets,” Credit Agricole’s Barbe says.
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