Emerging market’s boundaries broken down from desire for local opportunities
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If anything symbolizes how far emerging markets have come over the past five years, it’s the growth of their domestic capital markets. Few would dispute that emerging markets local-currency debt is now an established asset class, despite its relative youth. Local-currency debt is the way of the future, but further reforms are necessary.
Although its difficult to get exact figures, one banker reckons that corporates and financial institutions in developing countries issued about $125 billion of local-currency debt in 2005. Thats more than the amount that was issued by these same borrowers in the international capital markets.
In Asia (excluding Japan), the outstanding amount of local-currency bonds has increased by 167% since 1996. Eastern Europe, Africa and Latin America are also making progress. Borrowers in several countries, such as Russia, South Africa, Brazil, Colombia and Mexico, are more readily using their domestic markets to fund themselves, reducing their vulnerability to exchange rate risk. These markets can no longer be ignored and are the way of the future.
As the asset class develops, however, several questions are raised. The most fundamental is: what is local-currency debt? At its simplest, it is a bond denominated in the local currency, issued by a local entity, and sold to local investors.
But as these markets become more open, cross-border structures are also taking off. Last September, for example, Brazil issued a real-denominated Eurobond to attract international investors. Other emerging market borrowers, which are forbidden to place local bonds on the international capital markets, are instead tapping foreign investors by selling structured products in the private placement market.
Another development is foreign entities raising funds in local markets. Clearly the boundaries that define international and local markets are beginning to break down, especially in Asia.
The heterogeneity of the asset class is forcing banks to assess their approach. One investment banker in New York admits that his bank is still trying to grapple with how best to cover the local-currency markets. His is unlikely to be the only one. Global banks such as Citigroup and HSBC are well positioned to compete across a number of local markets.
But others will have to cherry pick. Some have already begun to do so. ING, for example, is making good headway in Mexico. The growth of the asset class is also helping to level the playing field for local banks, with institutions such as Bradesco, Woori Finance and ICICI featuring prominently in their respective local currency league tables.
Investors also view local-currency debt as an opportunity. Nearly all the big international portfolio managers and hedge funds are focusing on the asset class (both as an FX and credit play) in the hunt for yield.
However, these investors should tread cautiously. Most markets still have much work to do to improve accessibility and liquidity. International investors can only buy at the long end of the domestic yield curve in a handful of markets, such as Mexico and Chile.
Executing trades in other emerging markets can be time-consuming and difficult in Brazil, for example, international investors have to pay a transactions tax. In addition, to sustain genuine foreign investor interest, trades need to be settled internationally, but too few markets have up-to-scratch regulation.
Maybe 2006 will prove to be the year when governments finally act.