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Managing Risks: The Common Interests of Emerging Market Countries and Investors. Eliot Kalter International Capital Markets Department International Monetary Fund June 15, 2006. OVERVIEW Managing Risks: The Common Interests of Emerging Market Countries and Investors.

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managing risks the common interests of emerging market countries and investors

Managing Risks: The Common Interests of Emerging Market Countries and Investors

Eliot Kalter

International Capital Markets Department

International Monetary Fund

June 15, 2006

overview managing risks the common interests of emerging market countries and investors
OVERVIEWManaging Risks: The Common Interests of Emerging Market Countries and Investors

I. Growing underlying strength of emerging market (EM) countries

II. Improvements in EM sovereign debt structure

III. Broadening investor base for EM issues

IV. EM local issues as an investor class

V. The portfolio application of local markets

VI. Individual EM country valuation still matters

VII. Implications for International Financial Institutions

i underlying strength of emerging market countries
I. Underlying Strength of Emerging Market Countries

Cyclical factors underlying strength of asset class

  • Increased risk aversion reflecting investors’ assessments of global liquidity and changes risk aversion
  • Nevertheless, search for yield and credit spread compression
fundamental factors underlying strength of asset class
Fundamental factors underlying strength of asset class
  • Global financial position of EM Countries has dramatically improved in recent years
  • Strong growth of international reserves through capital inflows and current account surpluses
slide6

Emerging Markets: Current Account Balance and External Financing

(in billions of U.S. dollars)

25

improved debt structure underlying strength of asset class
Improved debt structure underlying strength of asset class

Improvements in debt management operations

  • Significant improvement in EM macroeconomic fundamentals has enabled public debt managers to be active in markets
  • Many EM sovereigns have made major strides in improving debt management capacity
  • Focus on reducing exchange rate risk, interest rate risk, and rollover risk
recent liability management activity
Recent liability management activity
  • Buy-backs of international bonds through early repayments to IFIs and the Paris Club, and retiring other foreign currency liabilities
  • In addition, market is seeing exchange warrants, pre-funding of fiscal operations, and the exchange of foreign- for local-currency denominated debt
  • These operations are transforming the market for emerging market assets
strengthened sovereign balance sheets
Strengthened sovereign balance sheets
  • Significant impact on the sovereigns’ debt structure
  • Resulting in strengthened ability to deal with negative cyclical events
slide12

Resulting in reduced external debt service

External Debt Service/Exports of Goods and Services

(in percent)

Emerging Markets

Latin America

Asia

Europe

slide14

Aggregated EMBIG Spreads – Actual and Model

(in basis points)

Corrections

Actual

Model

23

ii broader em investor base
II. Broader EM Investor Base

Foreign investors attracted to asset class

  • Ratings outlook positive and moves toward investment quality
  • Improved fundamentals driving asset class and opening door for broadened investor base
  • Tide of foreign investor inflows into emerging market assets
  • Technical factors also attract investors
local institutional investors growing in importance
Local institutional investors growing in importance
  • Banks still the largest domestic investors in EM sovereign debt
  • However, there is a steady increase in the share of institutional investors across EMs
  • While central banks reduced role in own domestic sovereign debt
  • Nevertheless, further deepening of capacity of local markets required
iii em local issues as an investor class
III. EM local issues as an investor class

International investors moving towards local-currency instruments

  • Sizable demand for external-currency debt while supply from EMCs is declining due to large external reserve build-up and policy to reduce “original sin” and develop local markets
  • The search for yield and declining returns on external debt has extended increasingly into local-currency instruments
  • Search for “alpha” likely to accelerate investor interest in local-currency instruments.
  • Limited supply of liquid local instruments relative to investor interest
institutional investors contributing to strengthened local capital markets
Institutional investors contributing to strengthened local capital markets
  • Growing MM institutional investor participation shifting from highly active short-term traders towards more strategic and buy-and-hold investors
  • The investor base is also diversifying geographically
  • Increasing role of MM strategic investors has contributed to improved quality and stability of external financial markets for EM debt
  • Moreover,growing prominence of institutional investors critical component of strengthen local capital markets
em debt managers have set objective of deepening local capital markets
EM debt managers have set objective of deepening local capital markets
  • EM debt managers are taking advantage of investor interest in local-currency issues to deepen local markets
  • Action taken, despite favorable terms in external markets, as insurance against “original sin”
  • Mention actions being taken by EMs….Debt Managers Forum
mutual benefits for em countries and institutional investors
Mutual benefitsfor EM countries and institutional investors
  • Virtuous cycle of deepening local capital markets and broadening investor base is taking place
  • Broader investor base enabling EM debt managers to use increasingly sophisticated portfolio management techniques to a better manage risks
  • Investors have new opportunities for hedging financial and exchange rate risks (with local derivatives markets)
  • Both investors and EM’s gain from ore stable markets less likely to sell-off in reaction to country-specific or creditor-specific shock
  • Both investors and EMs better able to reduce the currency and maturity mismatches associated with cross-border transactions
  • Nevertheless, caution is required on overly relying on foreign participation until capacity of local markets is enhanced
v portfolio application for local markets
V. Portfolio application for local markets

Benefit to institutional investors

  • Institutional investors search for risk-adjusted returns has driven the sizable foreign demand for local-currency EM debt
  • Investment in local-currency debt provides investors with assets that have different sensitivities to movements in interest rates and exchange rates than EM external debt
  • Lower duration of local debt provides some hedge against rising global rates
slide27

Emerging Market Indicators

Equity Indices

(1/1/2005 =100)

Currency Indices

(1/1/2005 =100)

Latin

Europe

U.S. trade-weighted

Latin

Europe

Asia

MSCI

Emerging

Markets

Asia

Local Bond Returns

(1/1/2005 = 100)

External Bond Spreads

(in basis points)

Latin

Latin

EMBIG

Europe

Asia

Asia

JPMorgan

GBI

Europe

21

vi individual em country valuation still matters
VI. Individual EM country valuation still matters

Implications for portfolio approach to local currencies

  • Market discriminating across asset class rewarding EM countries with stronger fundamentals
  • Important to look for structural achievements, taking advantage of current favorable environment

Bottom line

  • Countries included in portfolio of local currencies matter
vii broad implications for international financial organizations
VII. Broad Implications for International Financial Organizations
  • Underpinning of good macroeconomic and financial policies still required
  • Strong fiscal policy and debt management required
  • Help new market participants, principally lower income countries, to ensure their initial access to international capital markets is prudent
  • Help ensure that EMCs raise resources in sustainable manner and balance sheet risks remain within macro prudential limits, in the context of increased access to capital markets
implications for international financial organizations continued
Implications for International Financial Organizations (continued)
  • Widening the local investor base and broaden local market instruments, to make these markets more resilient to capital flow reversals
  • Encouraging debt managers to issue into this market with the objective of developing benchmark yield curves via a transparent and regular issuance policy
  • Government should be prepared to pay initial higher costs associated with domestic issuance for the insurance benefit gained from these markets
  • Investing in a program that disseminates information to and gains a good understanding of the needs of a countries investor base
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