Client Affairs

An Open Window Of Opportunity

Clark Winter Citigroup Private Bank Chief Investment Officer 15 August 2005

An Open Window Of Opportunity

In the late 1990s, a series of monetary crises and bond defaults in Asia and Latin America rocked investors and left them thinking that even...

In the late 1990s, a series of monetary crises and bond defaults in Asia and Latin America rocked investors and left them thinking that even rapid economic growth provided little guarantee of safety. Thailand, Mexico, South Korea, Brazil, Argentina and Russia, among others, all sprang leaks in their creditworthiness and made investors wary of their bonds. Fast-forward seven years: Many of the nations in trouble then have diligently enacted political and economic reforms. The casualties of the late 1990s have more than recovered: they now issue bonds not only denominated in reserve currencies but also in their own currencies. According to the Bank for International Settlements, Asian nations issued more than $1.2 trillion in local currency bonds from 1999 through to the end of 2004, of which about $270 billion was actually tradable, as tracked by Hong Kong & Shanghai Bank’s local currency bond index. The larger figure is equal to about 50 per cent of the GDP of the economies issuing them, and it already dwarfs the Asian holdings of US Treasury issues. Latin American local currency borrowing is much smaller, about $700 million from 2002 through the end of the first quarter of 2005. Overall, local currency borrowing has been rising at more than 24 per cent annually since 2003. What’s more, all this activity has opened a window of opportunity for locally focused investors in these markets. What’s driving the surge in new issuance? Partly, it can be explained by improved economic conditions. Many of the countries issuing bonds in their own currency are large commodity exporters that are piling up substantial foreign holdings. Brazil, which used to be chronically in debt, had accumulated nearly $53 billion in reserves by the end of 2004. Mexico, another chronic debtor, had almost $61 billion in foreign reserves on hand at the end of 2004. Asian economies were doing even better: South Korea’s reserves stood just shy of $200 billion as of the end of 2004, and China had about $610 billion. These reserve holdings give investors increased confidence of bond repayment, come what may. Local currency bond issuance is also rising because of repatriation. Money that had found safety and opportunity in global markets is returning to local markets for similar reasons. Since 2000, many foreign investors have been bringing their capital back home to put it into local commercial businesses and real estate. As those investments have fueled local economies, it has become burdensome to have to borrow in one currency and operate commercially in another. Local central banks — as well as sovereign and corporate borrowers — are finding it prudent to develop their domestic capital markets; local currency bonds are a key part. While this has proved a boon for stay-at-home investors, it is also providing a windfall for international investors. As bond fund traders become active in local currency bond markets, they are finding many of these issues are “mispriced” — that is, they carry higher interest rates than comparable reserve currency bonds issued by the same nation. This may be due to the lack of experience that investors have with these bonds, but as the experience curve rises, the spreads should begin to narrow. Indeed, emerging markets debt funds have been the best-performing segment of the fixed income sector for the past seven years, and increasingly, superior returns are coming from local currency issues. If interest rates remain low globally, many regions could have access to financing alternatives unforeseeable a few generations ago. That’s good for local economies. And although we are cautious on fixed income in general, there is a window of opportunity in local currency bonds that will not remain open forever.

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