Outstanding emerging market debt to expand this year, Merrill Lynch predicts

By Reshmi Basu

New York, May 4 - The tradable universe of emerging markets debt will continue to expand this year, according to a new report from Merrill Lynch & Co. titled "Size & Structure of the World Bond Market: 2004."

But the magnitude of growth will depend on whether emerging market countries become net issuers or net repayers of external bonds in 2004.

This "depends largely on the global backdrop, fundamental developments within the countries themselves, and the risk appetite among foreign investors," wrote the authors, global asset allocation strategist Cesar Molinas and senior finance consultant Gioia Bales, plus a team of other Merrill analysts.

In the last few years, a number of countries that bled during 1997 and 1998 downturn have improved their financial picture to the extent that have received investment-grade ratings, as some countries evolve from "developing" to "fairly developed."

South Korea, China and Poland, once definitive emerging market countries, are now A rated, altering the makeup of what is considered emerging markets.

Bradys shrink

Looking ahead, the outstanding volume of Brady bonds is expected to shrink as countries take advantage of lower eurobond spreads to retire the more expensive Bradys, the authors wrote in the report.

As Bradys fade, eurobonds are overtaking them as the most liquid emerging market debt issues. By the end of the first quarter of 2004 only two Brady bonds had issue sizes greater than $3 billion. Currently, nine eurobonds with greater than $3 billion have been issued.

At the end of 2003, there was only $44 billion in Brady debt remaining, or 25% of face value. Already Brady bonds represent 12% of sovereign external tradable debt. By the close of 2005, Brady bond could drop to under 5% of total tradable debt, Merrill predicted.

Also, emerging European debt will continue to fall "as more countries converge with the European Union and decrease their deficit financing, moving out of the Emerging Markets universe in the process," the report said.

Meanwhile, one interesting development is the creation of the Asian Bond Fund, where governments have contributed part of their reserves towards buying sovereign and quasi-sovereign debt. Recently, there have been proposals to extend the fund into local currency instruments. This would remove a key vulnerability in the region, the problem of currency mismatch, the Merrill analysts said.

Tradable debt up 12% in 2003

Looking back, in 2003, tradable emerging markets debt stock grew 12% over 2002 levels to reach $3 trillion. While the growth was higher than the 7% growth rate in the years after the 1998 Russian default, it lagged behind the annualized growth of 18% from 1993 to 1998.

The growth in 2003 was partly due to three drivers: demand for fixed-income debt, an exceptional recovery from a difficult 2002, and currency appreciation in several large domestic markets.

Meanwhile, foreign investors have increased their presence in the domestic markets in the past several years.

Domestic debt remained the leader in the emerging market debt universe, comprising 77% of the total. The majority of external debt is sovereign global eurobonds, Brady bond or local government bonds.

The stock of domestic debt, including government and corporate bonds, rose 11% in 2003, while external debt increased 15%, the first appreciable rise since 1997.

In 2003, Latin America and Asia continued to dominate. However, Latin America lost some of its share of the total debt outstanding.

"More debt is now represented by each of the three other regions, which indicates more global diversification in debt stock," wrote the authors. Latin America represents 48% of the external debt outstanding. Asian debt has increased by 25%.

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