Over the past five years, many emerging market countries have improved their macroeconomic fundamentals and debt management capability and have undertaken structural reform; some have benefited hand-somely from rising commodity prices. These developments have led to a significant upgrading of the emerging market sovereign debt class, almost half of which is now at investment grade. Low yields in mature market assets, coupled with improved quality and performance of emerging market assets, have increased mature market investor interest in the emerging market asset class. According to the IMF’s Global Financial Stability Report (GFSR), which takes a close look at 18 leading emerging market economies, the vulnerability of major emerging sovereign debt markets to external risks is declining and appears to be lower than in the 1990s. How-ever, emerging market countries should work to mitigate remaining vulnerabilities by pursuing sound macroeconomic and debt management policies.
First, global liquidity conditions and the potential turning of the mature market interest and credit cycles may leave some countries–particularly those with high debt-to-GDP levels–at risk for adverse developments. Second, macroeconomic performance is not uniform across countries, and even those with higher performance are better at taming inflation than at reducing fiscal deficits and debts. Third, while generally positive, growing investor involvement in emerging markets could reverse in the face of unexpected shocks. For these reasons, the GFSR recommends that emerging market countries continue to pursue sound macroeconomic policies, particularly prudent fiscal policy and flexible exchange rates; acquire deeper knowledge of their investor base; and continue to improve debt management to reduce vulnerabilities.
Emerging market countries have stronger external and fiscal positions and lower inflation.
|Total (public + private) external debt/GDP||32.2||28.8||–3.4|
Capitalizing on improved fundamentals
Since the Asian crisis, many emerging market countries have adopted more flexible exchange rate regimes, increased anti-inflationary credibility, strengthened economic and fiscal and current account performance, and accumulated foreign exchange reserves. Better data and timelier provision have accompanied these improvements (see table). The collective result is improved credit ratings and compressed sovereign spreads, which, together with low global interest rates, have helped reduce debt and debt service burdens.
Capitalizing on this success, many countries have improved their overall debt management operations and capacity. Emerging market debt managers have reduced exchange rate risk by decreasing the share of foreign currency-denominated debt; interest rate risk by increasing the share of fixed-rate debt, and rollover risk by increasing the average term to maturity, or duration, of the debt stock by lengthening maturities and smoothing the repayment schedule.
To reduce their exposure to foreign exchange risk, emerging market authorities have been repaying international bonds and issuing more domestic currency debt (see chart on page 151, top panel). Emerging market countries have been issuing more local currency bonds—the share of local currency-denominated bonds in marketable sovereign debt of countries in the sample rose by about 9 percentage points, to 82 percent between 1996 and 2004. This shift reflects the growing willingness of foreign investors to accept local currency, the rapid growth of the domestic institutional investor base in emerging market countries, and a recent trend toward de-dollarization.
Countries have managed rollover risks by increasing the average maturity of debt (see chart, middle and bottom panels). They have also reduced interest rate risk by extending debt maturities and increased use of nominal (fixed interest rate) bonds. While the average proportion of fixed-rate debt has increased somewhat, domestic sovereign debt varies widely across countries: it is mainly fixed rate in emerging Asia (except in Indonesia) and floating rate in Latin America. Some countries with a history of hyperinflation and/or volatile inflation rates issued more inflation-indexed bonds to extend the maturity of local currency debt.
Broader investor base
At the same time, the investor base in emerging market sovereign debt has become increasingly diverse. Although data on the composition of investors in sovereign bonds, particularly for external debt, are incomplete, two trends are nonetheless clear. First, foreign investors are increasing their exposure to domestic currency and domestically issued debt. Second, the share of longer-term investors among both foreign and domestic investors seems to be growing. The composition of investors in emerging market sovereign debt appears to be moving closer to that in mature market debt; the role and importance of institutional investors have generally increased, particularly at the long end of the maturity spectrum.
Foreign investors. The emerging market investor base is shifting from highly active short-term traders toward more strategic, buy-and-hold investors in international foreign currency issues. The growing presence of mature market strategic investors may lend greater stability to the emerging market sovereign asset class. The investor base is also diversifying geographically and through the inclusion of official investors. There appears to be a secular trend toward a higher allocation to local currency instruments within international investors’ portfolios. The data suggest the share of foreign creditors in domestically issued debt almost doubled between 2000 and 2005. Mature market investors have shown interest in international emerging market sovereign debt issues in local currencies because of their higher real yields relative to foreign currency issues. Moreover, foreign investors prefer the global bond structure because of the bonds’ familiarity and more efficient logistics. Some issues also avoid convertibility risks. The growing share and diversification of foreign investors and their interest in local currency debt are generally welcome news for emerging markets, but the trend also underscores the need for all emerging market authorities to maintain sound policies.
Domestic investors. The domestic investor base for emerging market sovereign debt has also changed over the past five years. Although the share of banks, the largest domestic investors, has remained high, it has gradually declined while the share of institutional investors has risen rapidly. Pension funds are the second-largest investor class, thanks to their steady growth in emerging markets. The share of pension funds in emerging market public debt is likely to expand as these countries implement reforms to create private pension plans.
Insurance companies are also becoming increasingly important. Mutual funds are still only marginal players in emerging market domestic sovereign debt, but their share is growing rapidly and is likely to continue to grow. Central banks are no longer important investors in their own domestic sovereign debt. The share of domestic retail investors has grown rapidly in some countries and declined in others. Finally, the share of domestic investors in externally issued debt has grown in tandem with the share of foreign investors in domestically issued debt, more than doubling over 2002–04.
Decreased risk exposure, increased maturity
Data: IMF, Global Financial Stability Report, April 2006.
To sum up, the investor base of emerging market sovereign issuers is widening. An increasingly diversified local currency investor base bodes well for longer-term financing, reducing exchange rate-induced shocks, and better functioning of domestic debt markets. The widening of the investor base has been induced partly by a cyclical search for yield and lower risk aversion and is thus reversible.
Becoming less vulnerable
Overall, the vulnerability of major emerging sovereign debt markets to external risks is declining and appears to be lower than it was in the 1990s (see chart below). Emerging market countries should build on their recent successes and mitigate remaining vulnerabilities through sound macroeconomic policies, especially prudent fiscal policies and flexible exchange rates, and, as recent evidence clearly shows, active debt management.
Less exposure to foreign exchange risk.
The declining share of foreign currency debt reduces emerging market countries’ foreign currency risk.
Data: IMF, Global Financial Stability Report, April 2006.
A wider group of countries could consider buying back external debt, exchanging foreign currency debt for local currency debt, and gradually lengthening yield curves. Some countries could benefit from improved investor relations programs and enhanced data transparency. There is also room for further developing local capital markets in major emerging market countries to help attenuate vulnerabilities and broaden the investor base.
Efforts to improve debt management should continue; in particular, emerging market issuers need to structure their debt to minimize costs subject to risk constraints that determine currency composition, maturity profile, and interest rates. They also need to ensure adequate size and liquidity for key benchmark issues and to strengthen institutional capacity. It is equally important to develop specific investor segments, such as domestic and foreign long-term institutional investors, and keep investors informed through investor relations programs.
Ceyla Pazarbaşioğlu, Hemant Shah,
Anna Ilyina, and Paul Ross
IMF International Capital Markets Department
Copies of the Global Financial Stability Report are available for $49.00 each from Publication Services. See page 160 for ordering information. The full text of the report is also available on the IMF’s website (www.imf.org).