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Learning from Past Crises

On the heels of the global financial crisis, as Europe discusses the implementation of painful austerity measures and the U.S. deliberates the continuation of expensive government spending, I cannot help but draw attention to the relatively good fiscal health of several emerging market countries.

While many investors across the globe continue to think of emerging markets as ‘backward’ compared to developed markets, I think this is somewhat of a misperception based on impressions from decades ago. Per capita income in some emerging markets may still be lower than that in developed markets, however on several other measures, some emerging markets actually look healthier than some developed markets.

In the mid-1990s, some emerging markets substantially relied on foreign financing, making these countries more vulnerable to shifts in foreign expectations and perceptions. Consequently, they experienced serious financial crises, such as in Asia in the late 1990s and in Latin America in the early 2000s. These crises brought sharply into focus the risks and costs associated with underdeveloped domestic markets and excessive reliance on external, foreign-denominated debt.

As a consequence, during the early part of this century, a policy shift took place in some emerging markets to avoid this vulnerability. They tried to reduce both their global level of external indebtedness and their level of short-term debt, empowered by current account surpluses in several countries. In parallel, they increased their national saving rates, most notably in Latin America, which saw its average domestic savings rate increase from 17% in 2001 to 22% by the end of 2008.[1]

In Asia, a consensus emerged that a sound banking system and a liquid domestic capital market were necessary to allow participation in the international financial system without excessive exposure to large, unanticipated withdrawals and speculative attacks. There was also a growing consensus that emerging economies should avoid excessive foreign-currency debt levels while continuing to boost local bond market issuance as well as international issuances denominated in local currencies.

As a result, some emerging markets have now become more stable thanks to the implementation of long-overdue structural changes following their “trial by fire” through these major financial crises. You could even argue that emerging markets are today fiscally healthier than developed markets in terms of foreign reserves, debt-to-GDP ratios and risk perceptions.

For example, foreign exchange reserves in some emerging markets surpassed those of some developed countries in 2005. China is the leading holder of reserves, with more than US$2 trillion, Russia has more than US$400 billion, while India and Brazil have reserves of more than US$200 billion each. In addition, the International Monetary Fund expects debt levels within developing economies to resume a “gradual decline” in 2011 from current levels of around 40% of GDP, while it estimates that the debt of developed nations will grow from 73% in 2007 to reach 110% of GDP by 2015.[2]

Finally, credit default swaps (CDS) of some emerging market countries recently traded at lower spreads than those of some developed European countries. The spread between emerging market sovereign bonds and U.S. Treasuries narrowed significantly, from a six-year high of 865 basis points in October 2008 to 287 basis points at the end of July 2010.[3] Meanwhile, the cost of insuring European sovereign debt against default has almost doubled this year. Historically, the trading of sovereign credit default swaps (CDS) was limited to emerging markets, reflecting the credit risk associated with the government debt of these countries. Over the past months, however, an actively traded CDS market in industrialized sovereigns emerged as a result of the financial crisis and growing concerns relating to the solvency of developed economies. Contracts on Greece, Portugal and Spain are now higher than developing nations such as Russia, the Philippines and Thailand.[4]

Although it is unrealistic to assume that the structural changes implemented in some emerging markets can completely shield them from the effects of future global crises, they seem to have borne the most recent global financial crisis reasonably well. While risks have not disappeared, things look a lot better today than they did 20 years ago. The growing use of derivatives contracts is just one of the many reasons to remain cautious, but I believe some emerging markets’ strong fiscal health are cause for hope and optimism.

[1] Economist Intelligence Unit. Latin American countries considered: Brazil, Chile, Colombia, Mexico, Peru.
[2] Fiscal Monitor, International Monetary Fund, 14 May 2010.
[3] JP Morgan, 31 July 2010.
[4] Markit, 30 July 2010.

September 2, 2010

Executive Chairman
Templeton Asset Management Ltd.

Mardi 14 Septembre 2010

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