The US Treasury yield curve has inverted as 3-month yield tops the 10-year yield. This is the first time that this has happened since 2007, and the WSJ noted that the move had preceded every recession since 1975.
As the clock is ticking towards a new recession (or crisis?) the question on everybody`s lips is: where will it start? Will it be the Eurozone and its sick man, Italy? Will it be the US with its newly formed housing bubble? Will it be the emerging markets once more?
As to the last in line, the Fed`s decision this week not to raise dollar interest rates and its signals that most likely, there won`t be an increase in interest rates this year, comes as good news. As the external debt of emerging countries is denominated primarily in dollars, the upward trend in interest rates started by the Fed was worrying. The percentage of the budgets spent on servicing debt would have gone up and would have strained fiscal policies.
But there are other reasons for optimism. The economic status of emerging countries has clearly changed compared to the late `90s when, mind you, propping up the exchange rate against capital outflows drained their foreign currency reserves. Furthermore, the fiscal policies in the last years have been prudent enough to lower their reliance on borrowing abroad. And having a considerable larger portion of the debt, whether financed by domestic or foreign investors, in the local currency makes all the difference.
Such a change proves to be critical in times of crisis when foreign capital tends to head back home and thus deprive emerging economies of much needed funding, especially in times of trouble. In a crisis scenario, exchange rates crash turning the debt service into a daunting task. Local currency funding does away with this risk. But not altogether.
Under unfavorable economic circumstances, local currencies come under downward pressure. Conventional wisdom dictates that central banks increase interest rates to make the currency more attractive. In addition, inflationary pressures resulting from a depreciated currency will require a higher interest rate as well.
Anyway, the lesson learnt by the emerging economies in the aftermath of the `90s crisis is that a flexible exchange rate is essential to cushion external shocks and safeguard foreign currency reserves. Although the currency depreciation shock might be significant in the short term, by increasing exports competitiveness and deterring imports the FX rate will help rebalance external deficits and lay the groundwork for economic recovery over the medium and long term.
This means, however, that in a crunch, foreign investors buying local currency debt will be subject to both interest rate volatility and currency volatility insofar that both start shifting in the same direction and against investors. This is why they ask for a risk premium to match, especially when the economic policies of the countries concerned are unpredictable, and their fiscal policies unsustainable. Simply because the FX risk has now switched from the sovereign issuer to the investor.
How can emerging markets lower their borrowing costs given all of the above? The answer is straightforward. Foster not only local currency funding, but also the development of large institutional investors because they will not have to factor in the FX risk since there isn`t one to factor in.
On that, Foreign Affairs noted the important role that compounding-based pension funds play in countries such as Chile, Mexico or South Korea in stabilizing the government bonds market and preventing shocks. This should not come as a surprise. Pension funds are long-term investors, less concerned about short-term market fluctuations and more likely to look at falling prices as opportunities of a good deal.
Despite all the local changes, however, emerging economies will unavoidably remain reliant on external funds for many more years to come. Therefore, their decision-makers should not interpret the periods of abundant global liquidity when investors run for assets as a sure sign of how good the country`s economic policies are. The best example here is Romania before the crisis when deficits ran abnormally high amid plentiful funding, and during the crisis when the funding tap was turned off revealing that in fact “the emperor had no clothes”.
Investors` frenzy replaces wise policies only in the short term. Emerging countries should not get drunk on ungrounded optimism.
Have a nice weekend!
