Emerging markets have tough act to follow

Financial News

January 4, 2004

Will the good times continue to roll for emerging market debt in 2004? That question faces bankers specialising in the sector as they look back on 12 months in which performance has far exceeded expectations.Emerging market analysts say that on balance it is unlikely to be another good year, though the market will be hard pushed in any event to match the 25% total return achieved in 2003.

The main issue for this year continues to be the state of the US economy. A surge in American growth could trigger inflation, forcing the Federal Reserve to put up interest rates.

This in turn would put up the real cost of borrowing for emerging market issuers. Recent low interest rates have encouraged sovereign borrowers, like Bahrain, and corporates to come to market even though they have not needed the finance.

Most significantly, it would reduce the attraction of the sector to institutional investors on the hunt for yield. If the US and European governments start to borrow on a large scale and pay more for their money, investors who flirted with emerging markets in 2003 may turn back to these safer investments.

There would be a double squeeze for investors as the expected tightening of prices for emerging market issues, particularly in Central Europe, Turkey and Brazil, will further reduce the attractiveness of these bonds.

A final concern is a return of political and economic instability. Since Argentina's default in 2001, the sector has had a remarkably trouble-free year. In 2003 the number of upgrades exceeded the number of downgrades for the first time in two years.

Brazil, which it was feared would go into meltdown after electing a left-wing government, has been one of the most successfully managed economies in recent months. Turkey, despite terrorist attacks, its increasingly edgy relationship with the Bush administration and its proximity to Iraq, has had a better year than many expected. The Asian recovery from the crash of 1997 continues to power ahead.

However, emerging markets rarely remain stable for long. The biggest area of concern remains Argentina, where negotiations between the government and its international financial creditors are deadlocked.

Another worry is Russia, where the attractiveness of corporate bonds has been more than offset in the past few months by the implications of the collapse of the merger between oil giants Yukos and Sibneft and the desire to await the outcome of the Duma and presidential elections.

Another trend is the continued desire of countries like Russia to replace their international sovereign borrowings with debt raised from the domestic market. It remains to be seen the extent to which international investors are prepared to take this currency risk, particularly when the dollar is weakening significantly.

However, according to Larry Brainard, senior adviser at WestLB, the net result of these factors has been good for emerging markets and many new investors have remained loyal.

He said: "Although differentials for emerging markets as opposed to other fixed-income classes have now closed for the most part, offering investors little incentive to switch, we have not seen a large-scale reallocation of investors' funds out of emerging market debt.

"Some of the more aggressive asset allocators have taken profits and gone elsewhere. But new inflows into emerging market debt continue, though at more moderate levels earlier in the year."

Another banker cited a fund manager who thought he was buying into the top of the market when he purchased emerging market bonds in June. Since then he has seen his investment grow by more than 7%.

Brainard believes it will be possible to attract more investors so long as bond fund managers are able to "validate expectations". However, he accepts that in 2004 it will be "harder to get even high single-digit returns".

One factor likely to maintain demand this year will be a shortage of issues. As terms are unlikely to be as attractive as last year, the number of new bonds is likely to be lower.

According to Dealogic, the data provider, 68 sovereign emerging market bonds were issued in 2003 to early December, worth [euro]41bn ($50bn), while some 272 corporates raised [euro]56bn.

One of the biggest markets will be Russia, which, despite its recent upgrading to investment grade, remains one of the most undervalued markets because of political uncertainty. It is likely to remain so until after the presidential election in March and until President Putin's approach to the oil companies bought by the oligarchs is clear.

The latest budget gives the government the authority to raise a $2.7bn Eurobond in 2004.

But Evgeny Gavrilenkov, chief economist at Troika Dialog, the Moscow investment bank, said he is not sure this will take place.

He said: "The budget assumes an average oil price of $22 a barrel and it is certain to be higher than that. So, just as was the case this year, there will be no need for a sovereign issue."

Gavrilenkov also points to the government's desire to reduce foreign currency debt and replace it with roubles. "In the next year I expect the government's foreign debt to drop by $5.5bn," he said.

As the political situation stabilises, Gavrilenkov expects corporate issuance, one of the highlights of the first half of 2003, to restart. This market dried up as the Duma election neared and the Yukos dispute began.

The figures make dramatic reading. In the first half of 2003, some $7bn of corporate foreign debt was issued, followed by $2.7bn in the next three months and virtually nothing in the rest of the year.

Gavrilenkov said large Russian corporates will have no alternative but to return to the market next year even if they have to pay more for their money. He said: "Big corporates cannot raise the finance they need locally because the Russian banking system is too small. There is no way that a company like Lukoil can raise $1bn to $2bn locally."

Argentina remains a main concern, even though its default did not prove contagious. Despite improvement in recent months, with the fiscal goals imposed by the IMF being met and a strong recovery in GDP, the outlook remains difficult.

Neil Dougall, analyst at Dresdner Kleinwort Wasserstein, said: "Clouding this picture is the continuing uncertainty over the terms and timing of the debt restructuring."

Negotiations between the Argentine government and creditors, who are owed more than $60bn, are continuing. However, a gulf remains between what the government is offering, which includes new bonds worth about a quarter of the existing debt, and what the creditors want.

The odds are that a deal will be struck. But, if it is not, there will again be a question of just how safe emerging market debt is.

That could have implications for the whole sector.

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