Emerging markets go back to future as debt piles up

08/01/2010 | Sid Verma

The global financial crisis has transformed emerging market sovereign risk premiums and debt management tactics. Countries need to tread carefully as they return to external debt markets to meet rocketing financing needs.

Developing economies began a new era in public financial management at the turn of the century. Battered by currency mismatches and debt crises, sovereigns shunned external bond issuance for domestic capital markets in an era of restrained public spending.

The global economic boom helped too. In Asia, thriving exports endowed many governments with fiscal surpluses and domestic capital markets provided any necessary government financing. This left Indonesia and the Philippines as the only players in global bond markets from the region.

In Latin America, Brazil and Mexico relied on commodity exports and domestic banks to finance the budget. As a result, when Latin sovereigns launched global bonds they did so to pay for upcoming external debt maturities and to provide benchmarks for domestic companies. Meanwhile, tight EU rules on public spending capped external bond issuance by aspiring eurozone members.

So the global bull run was accompanied by a revolution in the emerging market debt universe driven by waning external sovereign bond supply and a jump in local currency debt. Locally-issued sovereign debt outstanding across emerging markets increased from $1.43tr in 2002 to $4.47tr in 2008, according to Bank of America Merrill Lynch. This growth contrasts with stagnation in the stock of external sovereign bonds in a range of $400bn-$500bn over the same period.
Then came the storm. Over the past two years, emerging markets have experienced the biggest upheaval since the Asia crisis in the late 1990s. Collapsing trade, plunging domestic consumption and vanishing revenues infected economies across the globe. But then came the flood. Governments bolstered public coffers by raising capital from multilateral development banks, the IMF, aid donors and — crucially — the market.

According to BofA Merrill, sovereign bond issuance in global markets in 2009 will be around $77bn — double that of the previous year. And this large-scale borrowing is on the cards for the next two years at least. The bank forecasts new external bond issuance in 2010 of $93bn, a 21% jump from 2009.

A big part of this year-on-year increase is down to an anticipated $17.8bn of Russian sovereign bonds expected to be issued in 2010. Some $62bn of new capital raising in international markets is expected to come next year from triple-B or lower-rated sovereigns while single-A and double-A countries will issue $31bn of bonds.

"The sovereign landscape has changed tremendously," says Jonathan Brown, head of emerging markets and European credit syndicate at Barclays Capital in London. "For the two to three years prior to the crisis, many sovereigns concentrated on pre-financing their debt, redeeming bonds, cultivating the local market and, in many cases, were net payers of debt — but now funding needs have jumped up."

Outside the triple-B bracket, sovereign issuance has been dominated by high-grade but revenue-starved eastern European economies. Poland, Slovenia, Slovakia, Czech Republic and Lithuania — all single-A rated or higher — have issued a total $18bn this year.

Turkey stays on track
As emerging market issuers seek to make a splash in global markets, opportunism and flexibility are key.
Turkey, for example, has launched bonds this year with well-timed and quickly executed deals. "Although there is a significant improvement in the market conditions since the beginning of the year, we still believe that the windows of opportunities are likely to appear at short notice and are likely to be short lived going forward," says Memduh Aslan Akcay, director general of foreign economic relations at the Turkish treasury. "We believe that flexibility and quick decision making would be the key elements of success in this market environment."

Turkey in recent years has been one of the largest sovereign issuers in EMEA. It issued $3.75bn of new paper in 2009 and in the coming years will raise an annual $4bn-$5bn in international markets. Turkey has grabbed cash quickly in the face of the downturn thanks to its well-developed yield curve that provides clear and liquid pricing points for investors.

Domestic investors made up around 70% of the books for Turkey’s dollar bonds in 2008. Some observers criticised those deals for failing to penetrate the foreign investor base — but the bonds outperformed the CEE region as well as many Latin American sovereign peers in the grip of the crisis during the fourth quarter of 2008. This was due to the buy-and-hold nature of many of Turkey’s domestic investors.

That is in contrast with sovereigns with greater foreign exposure — which suffered price volatility in the flight-to-quality sell-off after the collapse of Lehman Brothers. This episode may have tempered the enthusiasm of issuers to diversify their investor base, said analysts at the time.

But Akcay says Turkey is not in that position. "Although we don’t have a certain ratio for the distribution of bonds to domestic and international investors, it is certain that we are trying to maximize the non-resident allocation to the extent possible."

Brown at BarCap says that the borrower is in good position. "If they don’t get the demand they want from foreign investors then they can sell external bonds to locals."

Turkey recognises the merits of global distribution of debt, says Akcay. "We don’t see the domestic market completely replacing the international market and we will continue pursuing the goal of increasing the appetite of foreign investors to Turkish assets."

A brave new world
As sovereign borrowing needs jump, issuers have plunged into diverse markets with new benchmarks. Take the case of Poland. In July, central and eastern Europe’s largest economy (A2/A-/A) launched its first dollar benchmark in four years with a $2bn 10 year bond at a spread of 290bp over US Treasuries. As the public finances sank deeper into the red, it subsequently re-tapped the dollar benchmark for another $1.5bn. Benchmark issuance in a 10 year tenor is the sweet spot for investors in the liquid US market, while euro denominated credit is usually in five year format. This boosted the appeal of issuing the dollar benchmark, says Anna Suszynska, deputy head of the public debt department at the Polish ministry of finance.

"The five year maturities in our yield curve were getting quite crowded, and we wanted to issue in dollars for diversification purposes," she says. "The pricing in US markets was not as good as the euro markets in recent years but this has changed."

Nevertheless, despite the competitive pricing for the Poland dollar deal relative to euro issuance, all-in funding costs have leapt up. In 2005, Poland issued its 10 year, $1bn benchmark at a spread of 59.8bp.

Poland also returned to the Samurai market after an absence of two years to price a ¥44.8bn ($495m) dual tranche transaction in November. Suszynska says Poland is issuing in diverse, global markets to ensure domestic borrowers were not crowded out by the large supply of zloty government paper.

Poland doesn’t always swap foreign currency bonds into zloty, so its reference level for new issues remains the 10 year government zloty paper that typically yields 6%-7%, says Suszynska.

In the years preceding the crisis, central and eastern European issuers were much in demand from investors who expected eurozone convergence to result in rapid price performance. Partly for this reason, these countries were able to sell bonds with low new issue premiums.

But the regional economic slump and the repricing of risk globally transformed central and eastern European credit, in many cases, into a mainstream emerging market product with concomitant higher financing costs.
"We have found it quite a challenge to find euro investors for quite a few sovereigns in the region," says Jonathan Brown, head of emerging markets and European credit syndicate at Barclays Capital.

Amid the wreckage of euro convergence funds, Lithuania, for instance, issued its first dollar benchmark in a decade in October, a $1.5bn deal. "You have Greece and Italy that have multi-billion euro funding needs, have access to deep liquidity and benefit from narrow bid/offer spreads," says Brown. But it’s a different story for central and eastern Europe.

Elsewhere in the region, countries have gone cap in hand to bilateral and multilateral donors as well as raiding reserves rather than relying on commercial financing. For example, Estonia faces a 2.95% budget gap in 2010 but has deployed its reserves accumulated before the downturn and cut spending rather than launching bonds. These moves are aimed at ensuring the Baltic nation does not breach the 3% deficit target to join the eurozone. As a result, Estonia also has no plans to either develop a local debt market or launch a Eurobond over the next two years. "We have few market-makers and banks so there will be no point in creating a domestic government debt market," says Ülle Mathiesen, head of the state treasury department at the Estonian ministry of finance.

Diverse diet
But this is the exception rather than the norm. The list of emerging market sovereigns launching funding initiatives in new currencies this year includes Indonesia, Colombia, Mexico and the Philippines, all of which have issued in Japanese yen.
"The global economic cycle has put tremendous pressure on government budgets and so countries in emerging markets and the developed world have been diversifying their funding sources," says Andrew Dell, head of emerging markets debt syndicate for the CEEMEA region at HSBC.

Julian Trott, head of debt origination for CEEMEA at BofA Merrill, predicts this trend is set to continue as global credit markets thaw. "The premium for diversifying into other currencies has gradually come down over the past six months," he says.

However, it is unclear whether diversified issuance will prove to be a long-term phenomenon. Are borrowers broadening their financing horizons to insure themselves in case their principal funding market seizes up or are they just rushing to grab money where they can? Michael Schoen, head of Latin America and CEEMEA debt capital markets at Credit Suisse, says it is most likely the latter. "Diversification is a cyclical phenomenon and is a function of market conditions in any given point in time." But Dell warns: "Diversification has to be a longer-term process and is most appropriate for larger issuers."

The ranks of sovereign issuers is set to expand in 2010 with the re-entrance of Russia. "The 800lb gorilla is the expected Russian sovereign issuance for next year. They have not issued since 1998 and their large multi-year funding needs going forward shows just how much the market has changed with respect to new supply," says Trott.

Russia might raise up to $17.8bn from the international markets next year, based on an assumption of an oil price at $58 a barrel, Alexei Kudrin, deputy prime minister and finance minister, said recently. With this jumbo issuance, Russia would become the largest sovereign issuer in all emerging markets.

Such large, multi-year funding plans should set off a sea change in debt management tactics, says Trott. "Historically speaking in emerging markets, quite a few sovereigns have been able to be pretty relaxed in the way they operate when compared with SSA issuers or other sovereigns in the developed world." And he says large sovereign issuers would benefit from having a transparent funding strategy with clear issuance calendars, preferred benchmarks and performance metrics for banks.

Sovereign issuers have plunged into global markets as historically low rates and massive liquidity injections by developed central banks have driven a rally for risk. And since March external sovereign risk premiums have fallen to pre-crisis levels. "Ten years ago, many emerging market borrowers were paying double-digit coupons but now yields for many are around 5%-7% so levels look extraordinarily reasonable," says Dell. But will emerging market sovereigns continue to price bonds at ever-aggressive spreads given the large supply? Trott at BofA Merrill warns that large deal volumes combined with front-loaded issuance — in order to pre-empt a rise in borrowing costs next year — could spark execution risks. "Sovereigns who are the third to issue, in say a week, may get crowded out if markets are volatile."

It’s the economy, stupid
Dell at HSBC says the market will comfortably absorb sovereign paper because of the attractive risk-return metrics in many EM economies. Changing risk perceptions have created a portfolio shift in EM’s favour, says Brown at BarCap. "Emerging markets have largely performed well in this credit cycle and have attracted new inflows of high-quality, real money capital. As a result, we will see a balance between new inflows of capital and new supply in the EM sovereign market next year."

But the fate of sovereign credit ultimately lies in the hands of central bankers and finance ministers in the G7. Says Dell at HSBC: "The volume of high-grade issuance from developed sovereigns is going to be very significant in 2010 and that will ultimately weigh on single-A and double-A spreads which, logically speaking, will feed through into other assets."
However, in the longer term, debt capital markets bankers argue the crisis has created a structural bull run for EM sovereign credit. "You might like to say that the developed and emerging world took one step back in the crisis but then the emerging markets took two relative steps forward, which is one indicator of a structural shift," says Paul Tregidgo, vice chairman of debt capital markets at Credit Suisse.

And investors this year have bought into the hype. Markets shrugged off Ecuador’s sovereign default in 2008. Primary markets across the globe welcomed Indonesia and Poland with open arms despite surges in public indebtedness. Meanwhile, some countries could snub foreign currency bonds while Brazil is now even trying to choke off capital inflows.

It’s all down to the economic fundamentals. In the late 1990s, unexpected runs on dollar liquidity spelt disaster for southeast Asian and Latin American economies. This triggered governments into action to reduce dollar-denominated debt and run budget surpluses. So low public indebtedness in Asia and Latin America, reduced currency mismatches among borrowers, and counter-cyclical monetary and fiscal firepower has served to barricade many emerging economies from the global hurricane.

Despite the historically cheap cost of funding in international markets, it’s worth putting EM sovereign issuance into perspective. BofA Merrill predicts $93bn of EM government global bonds in 2010. By contrast, the US treasury sold $123bn of paper in the last week of October alone. "I’m more concerned about supply from the non-EM sovereigns than I am from EM sovereigns," says Tregidgo at Credit Suisse.

Emerging market nations have generally avoided large-scale international borrowing due to a fact of life: all countries are not equal despite the growing sophistication of many developing economies. For example, the flight-to-quality sell off after the collapse of Lehman Brothers triggered portfolio managers to repatriate capital and snap up G7 government paper. This shift caused the widening of sovereign bond spreads of emerging market countries. By contrast, the cost of public debt servicing for developed countries was sharply lowered.

This served as a wake up call to emerging markets as they incurred the wrath of foreign investors and reaffirms how developed and developing countries, in many ways, are in a league of their own. That’s because emerging economies typically hope to keep borrowing to a minimum, mindful that weak confidence in the sustainability of public finances has historically conspired to create havoc in their economies. This stands in stark contrast to the sky-high deficits and unbridled government spending in the G7.

Emerging markets then are set to capitalise on an array of funding sources in the coming years. But it will be a long while before markets tolerate their fiscal deficits in the same way as the so-called mature economies.

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