It might not be a great year for emerging market returns, but real progress is being made in perhaps the most important part of, well, emerging as a market – the development of local financial markets.
The banks on Euromoney’s shortlist for world’s best bank for public-sector clients were all hard at work during the awards period helping EM clients reduce their exposure to the appreciating dollar through liability management exercises on outstanding debt issues or FX solutions such as cross-currency swaps on dollar denominated loans. As EM debt continues to get pounded this year and the dollar continues to rise, it is becoming clear how important that trend has been for those economies.
But developing local capital and financial markets means more than helping EM and frontier borrowers build a debt profile in local currencies. It is also about helping them develop the market infrastructure, knowledge and diverse investor pool necessary to pull through routs like these without getting hamstrung in the long term.
EM debt is down across the board this year, as the dollar appreciates, oil prices rise and the world edges closer to a global trade war. Citi research shows dollar-denominated EM sovereign debt was down 5.7% in the first half of 2018. Citi’s Emerging Markets Government Bond index, unhedged, was down 2.1%.
Cycles like this aren’t, of course, new or even rare. This time around many of the EM sovereigns will undoubtedly be better placed to ride it out, thanks to the efforts of banks like HSBC, Citi, Barclays and Lazard.
Other developments, like improved collective action clauses (CACs) in EM bonds issued under New York and English law, will help EM borrowers restructure more efficiently if and when they need to. Older CACs required a supermajority of bondholders to agree to restructuring terms. Getting that supermajority across numerous bonds can be difficult, costly and time consuming.
Newer CACs, like the so-called dual-limb aggregation clauses first suggested by the International Capital Market Association in 2014, have features that allow sovereign borrowers much more flexibility in restructuring.
“They are now becoming a market widely accepted standard,” says Eric Lalo, managing director at Lazard. “The two-limb aggregated voting procedure, with 66% aggregate approval [applied across all affected instruments] and 50% approval per affected series will prove very useful in future restructurings,” he says.
But perhaps most important of all are developments on the domestic market front. Programmes like Euroclear’s i-link, which connects local central securities depositories with its international clearing system, can boost local investors’ ability to trade with foreign counterparties and local issuers’ ability to tap international demand. Such programmes have gained further traction in the last 12 months.
International investors will come in, and even carry the FX risk, if they are convinced they can exit fast through established procedures that are reliable and not costly- Eric Lalo, Lazard
“This has been extremely powerful for the development of Russia’s OFZ market and very helpful for Panama and Peru as well, for example,” says Lalo. (Russia struck its agreement with Euroclear in 2012, Panama in 2014 and Peru in 2017.)
“What is key if you want to attract foreign funds into the domestic market is adequate liquidity. International investors will come in, and even carry the FX risk, if they are convinced they can exit fast through established procedures that are reliable and not costly,” he adds. “We suggest very strongly that EM public clients develop efficient clearing and post-trade mechanisms before selling local currency bonds abroad.”
Ukraine became the most recent example of this approach in March this year, announcing it would soon come to an arrangement to create an international link to its depository system via a major international clearing house, reducing friction costs for international investors associated with buying hryvnia-denominated securities – and potentially boosting foreign reserves.
Ukraine knows all too well the dangers of becoming beholden to a small cadre of powerful international investors. It is still in the process of restructuring a $3 billion bond held by Russia. Another 13 bonds, which were restructured in 2016, had been the source of headaches for the sovereign, as Franklin Templeton owned half of them, according to Lalo and colleague David Gadmer. “That created difficulties and tensions in the restructuring negotiations,” says Lalo.
Kazakhstan has also recently struck agreements with Euroclear and Clearstream. Its domestic sovereign bonds will be ‘Euroclearable’ later this year. The Development Bank of Kazakhstan sold its first tenge-denominated Eurobond in December. And more seem to want to join in on the trend; Euroclear says it is aiming to expand its international links to Latin America and Asia.
This is all good news for the development of local capital markets globally. Attracting international investors isn’t a good thing in and of itself. In the past it has seemed that every time a new frontier or EM issuer sells a Eurobond, regardless of whether or not it is part of a programme of issuance, it is hailed as ‘sophisticated’ and having ‘a strong credit story’. And the fact that a handful of mammoth yield-starved institutional investors buy such bonds is touted as a proof of concept. But it isn’t always so.
Building an infrastructure that helps to attract a diverse set investors who can trade cost-efficiently in a liquid market is really the first step. It is also the key to avoiding being locked out of the market for prolonged periods of volatility, or becoming subject to the interests of a few hegemonic international investors.