Strong fundamentals ease emerging markets' transition to rising rates, IMF says

By Reshmi Basu

New York, Sept. 15 - Emerging markets are adjusting to a changing universe of interest rate hikes, but strong fundamental have made the adjustment less volatile, according to the International Monetary Fund's semi-annual "Global Financial Stability Report," released Wednesday.

In October 2002, an emerging market rally began that led spreads to 10-year lows. But the gains quickly unraveled this April as interest rate expectations changed along with investors' risk appetite.

"Mounting expectations for interest rates affected spreads in part due to the unwinding of the carry trade," said the report.

Dedicated and crossover investors reduced their risk by raising cash, moving up the credit quality spectrum and reducing the duration in their portfolios.

But once interest rate expectations stabilized, emerging market spreads began to narrow by mid-May.

Strong country fundamentals have helped ease the transition into the higher interest rate environment.

"There were no severe dislocations for either investors or issuers," said the report.

"However, the blunt of the sell-off was born by higher-yielding credits. Notwithstanding a subsequent recovery, by end-July the Dominican Republic, Brazil, Peru, and Turkey still showed losses year-to-date."

Nonetheless, sub-investment grade credits have outperformed during this rally. The difference between average spreads on B rated sovereigns compared to BB rated or investment-grade sovereigns began to tighten following the sell off in April and May.

"Looking ahead, the main external risk for the asset class remains the possibility of another round of de-leveraging. Expectations for a significantly faster pace of monetary tightening in the United States could lead to further risk aversion and higher spreads on emerging market bonds as speculative positions are reduced," said the report.

Another concern is too much supply, "in particular due to the still large remaining financing needs in part of the emerging market corporate sector."

Adding to the supply worries is the possibility of further Paris Club-related issuances by bilateral creditors similar to the Aries deal.

Despite these risks, there are a number of factors giving a lift to a favorable external environment.

In the first half of the year, 80% of planned sovereign issuance had happened, "despite the temporary lull by in issuance by sub-investment grade sovereign borrowers during the second quarter of 2004."

And credit quality of sovereigns appears to be improving.

'To the extent that interest rates eventually reach cyclical neutral levels and yield curves fatten, the incentive for leveraged carry trades will diminish. Hence, the importance of domestic fundamentals as the dominant driver of emerging markets is likely to reassert itself," according to the IMF paper.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.