The financial progress of most emerging economies has been spectacular in recent years. One indicator of this success is the decline in interest rate spreads over US treasuries on emerging market external debt. In 2003, this averaged 452 basis points (bp) over US treasuries. Now, however, these spreads are at historic lows, well below 200bp over treasuries, despite the 425bp tightening from the US Federal Reserve Board in the past two years.
Markets do not always get things right but our proprietary external debt model shows that improved economic fundamentals explain almost all of the decline in spreads in recent years. Moreover, a narrow focus on external debt developments understates the degree of progress evident across a broad array of emerging economies in recent years.
Stronger currencies
Emerging market currencies are now generally strong, not weak (witness the debate over China’s currency policy). An increasing number of emerging economy governments overcame what academic economists dubbed “original sin” a few years ago – that is, the inability to issue long-term fixed rate debt denominated in local currency. In the near future, for example, Mexico is poised to launch a 30-year fixed rate bond denominated in pesos. The term “emerging markets” thus seems highly appropriate. Indeed, the rapidity of change and development in the financial condition of emerging economies is stunning.
For policy makers, producers, consumers and investors in mature, high-income countries, these rapid developments raise both opportunities and concerns. The opportunities are plain to see: for consumers, emerging economies continue to offer a consistent flow of low-cost, high-quality goods and services. For producers, globalisation offers new bases for production as well as new markets. For investors, all these opportunities add up to the likelihood of excess returns, partly resulting from the strong growth that is resulting from better policies in emerging economies, and partly resulting from the decline in risk premia that were previously attached to emerging market assets. And for policy makers in high-income countries, there is the non-trivial benefit that emerging economies have now become net exporters of capital, which must surely be playing a role in keeping the cost of capital down for G8 governments that are hungry to finance large budget deficits.
An unprecedented development is now taking place: it is the governments in high-income countries that are running large budget deficits, while lower income emerging economies generally enjoy strong budget positions.
Financial distortions
At the same time, however, most emerging economies operate their financial systems with significant distortions. To some degree, these distortions are long-run vestiges of a bumpy development process. In China, for example, the financial system is evolving rapidly, from a fully communist system just 30 years ago – although it still has a considerable distance to travel.
In some cases, however, the distortions are the result of drastic actions taken during the regular emerging market crises of the period 1994-2001. For example, Argentina was in such dire straits after the collapse of Convertibility in 2001 that it chose to introduce a number of controversial measures affecting domestic and foreign investors. The country has made impressive progress in recovering from its deep crisis, and reached agreement with the bulk of its external creditors in 2004. The authorities are determined to avoid a repeat of their depression period of 1998-2001, however, and have implemented a series of somewhat controversial policy measures, including the use of price controls (many of which affect the financial performance of companies operated by foreign direct investors) as a tool of inflation control.
In other cases, there is a combination of the two problems. In Russia, for example, the financial system that resulted from the collapse of communism in the early 1990s left much to be desired, as was revealed by the 1998 crisis. The system that has developed since is partly the result of the patches put in place in the aftermath of the crisis, and is also not without its problems and distortions. But it has helped to deliver financial stability and growth (albeit aided considerably by the national wealth windfall resulting from the surge in global oil prices).
There are many other examples of important emerging economies that maintain significant capital controls and other distortions to their money, banking and capital markets (for example, Brazil and India).
These financial distortions are likely to become an increasing source of irritation to G8 policy makers in the months and years ahead. Such a development is already evident in the widespread irritation expressed over China’s currency policy. The IMF has recently been charged with preparing a report to highlight some of the factors hindering the correction of international imbalances. When it reports, it is quite likely that its staff will be under pressure from their high-income members (who still control the majority of votes on the IMF board) to focus on a number of the distortionary financial policies in emerging economies (particularly China). Expect to hear more voices calling for a level playing field in global capital markets.
Although Barclays Capital is sympathetic to the longer-term objective of true global capital market integration, it is also convinced that the progress towards full integration and its logical corollary – the implementation of best practice standards across all systems – will be a slow process and possibly a bumpy one.
At Barclays Capital, we strongly believe that the correct approach of both policy makers and capital market participants is to engage with their peers in emerging market economies in an effort to promote change and convergence, rather than taking a confrontational stance in an effort to force change. This does not mean that we believe the status quo is an ideal state of the world. Rather, we would argue that change should be expected to be gradual, and is best achieved through consultation and advice rather than through brute force.
Academic shift
In recent years, there has been a remarkable shift in academic thinking about the issue of sequencing of reforms in emerging economies. Throughout much of the 1990s, the emphasis was on rapid capital market integration, both as a means of importing savings and ensuring their efficient allocation across the economy. The alarming regularity of financial crises in emerging economies in the 1990s has led to a rethink of this conventional wisdom. Instead, most now accept that reform of, and stability in, the domestic financial system are necessary conditions that should be in place before capital markets are fully opened up to foreign inflows.
Foreign institutions can and should play an important role in such reforms – witness the surge in private capital into China’s banking system in recent years. We believe that policy makers in both emerging and high-income countries would be well advised to follow this strategy, with both retaining an open mind. Although there is a set of best practices that constitute an ideal for how global capital markets should be organised, the combination of historical accidents and local political and cultural constraints mean that the convergence of this ideal is a marathon, not a sprint.
It is of utmost importance that international financial institutions do not take advantage of more inexperienced and unsophisticated markets, and show restraint in their pursuit of financial gain by introducing speculative instruments and banking systems, which have not achieved the degree of development to deal with leverage and would lack the guts to deal with stress situations.
Philip Sutherland, head of emerging markets, contributed to this article.
