At some point in the next two quarters, the global backdrop for emerging market bonds will turn increasingly gloomy.
The global economy is in a stuttering recovery. For one thing, corporate America has to restore profit margins. So it has to cut wages, which it didn’t do during last year’s phoney recession. Second, the US housing market – a mainstay of household wealth creation during the US equity market meltdown – won’t keep on working the same magic.
Despite a slow global recovery, central banks will gradually tighten monetary policy. And global bond markets are also going to have to price in the US as a much bigger borrower. So interest rates will rise and yield spreads on emerging-market bonds will widen.
That’s the most likely prospect. There is an even darker one, to which I ascribe a 40% probability. US equities will head south as corporate profit growth comes in way below expectations. There will be a big hit to household net worth and consumer confidence.
If this happens, the US could grow much less than expected. When the US grows slowly, the world stops growing.
Which emerging markets will suffer most?
In Asia, the Philippines is most vulnerable. Philippines dollar bond yield spreads over US treasuries are at a four-year low. Yet public sector debt is 100% of GDP and rising. Tax revenues are just 12% to 13% of GDP and 13% below budget targets this fiscal year. So if global interest rates rise and yield spreads widen back to the historical average, interest costs will eat up the budget.
President Gloria Macapagal Arroyo is a worthy women but her commitment to economic reform is limited. Her popularity is declining. Deposed president Joseph Estrada could even win against her if he can delay a court conviction until the next election. So Arroyo is starting to do populist, stupid things that political panic dictates – reducing electricity prices by 20%, for example.
Sure, most of the Philippine government’s funding needs for this year are complete (though not some considerable off-balance-sheet stuff). But that’s in the price. And the dividend for investors gleaned from the global alliance against terrorism is spent.
The most vulnerable economies are in Latin America. Mexico has been the great success story since 1995. It has been converging towards economic integration with the US and away from its volatile southern neighbours.
But Mexico is a convergence story that has gone too far, too fast and its financial assets are now too dear. The peso is overvalued. There is no prospect of fast-forward on the rule of law, monetary union with the US or fiscal policy for Mexico as for Poland and the EU. Yet Mexico’s and Poland’s convergence stories are priced much the same by markets.
Capital flows to Mexico will decline as the US recovery stutters. So its economy will stutter even more than its northern neighbour’s. President Vicente Fox’s fiscal reform programme is a pale shadow of his fine intentions. The truth is, Mexico has a worse tax revenue base than the Philippines. Sure, Mexico’s public sector debt to GDP isn’t as bad but it doesn’t justify such a small 250 basis points yield spread to US treasuries.
The winds of populism are sweeping across Latin America. Venezuela and Argentina are telling us something. Magical realism may be a spent literary force but magical nonsense is gathering steam as an economic one.
The upshot is that red flag-waving throwback “Lula” (Luis Inácio da Silva) looks like becoming Brazil’s next president. He’ll wreck the reforms Fernando Cardoso started but didn’t finish. The bottom line is that gas-guzzler Brazil needs to pull into the international capitalist filling station every year and tank up with $25 billion to $50 billion. If Lula’s at the wheel, the pumps will be dry and shut.
Brazil’s foreign debt enjoys yield spreads bang on the five-year average at 900bp. But when there’s the smell of burning in the air, spreads can jump out to 1,500bp to 1,700bp. And today’s spreads reflect none of the risks in the domestic political situation.
The other country at risk is one that has benefited from the war against terrorism – Turkey. But that’s already in the price of its sovereign debt, which is trading on a 600bp yield spread to US treasuries, half the level in the crisis of last summer and well below the long-run average.
The only consistent characteristic of Turkish politicians is that they couldn’t run a candy store. With prime minister Bulent Ecevit in hospital, the prospects for an early election have risen. That will put reform on hold.
To maintain support for economic reform, Turkey’s politicians have to get the economy going. They can’t do that without fixing the banks. But bank restructuring is stuck at the state capital injection stage. There’s no sign of a real effort at foreclosure and asset liquidation. So the financial sector, with its massive asset and liability external mismatch, won’t be lending money to the corporate sector. The reform plans will collapse and so will the lira.
Asia’s economies may be recovering but other emerging markets are nearly stagnant. So emerging economies with big foreign currency debt burdens in an environment of rising global interest rates are in for a tougher time.
