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Emerging Market Debt:
an Analysis of Local versus Hard Currency
For professional clients only
January 2014

First State Investments
Emerging Market Debt
Manuel Cañas,
portfolio manager
in the First State
Emerging Markets
Debt team, discusses
the relative merits
of local and hard
currency debt.
Manuel Cañas – First State Emerging
Markets Debt
Manuel is a Senior Portfolio
Manager in First State Investments’
Emerging Markets Debt team,
where he is responsible for
researching the Latin American
region. Before joining the company
in November 2011, Manuel spent
four years with ING Investment
as Senior Investment Manager of
Emerging Markets Debt funds and
four years with the Central Bank of
Argentina. He has a total of 15 years’
experience in emerging markets.
A CFA charterholder, Manuel holds
a Licentiate in Economics from the
University of San Andrés. A native
Spanish speaker, Manuel is also
fluent in Portuguese.
External debt and local currency debt have a lot in common, with the
return on both dependent on the EM (emerging market) risk premium.
The historical yearly correlation of returns between the two is 0.79.
If overall market conditions are conducive for risk-taking, the risk premia
embedded in both external and local assets should compress.
However, some key drivers for EM external and local debt performance
differ, which implies that over the course of the global business cycle,
their respective expected return/risk profiles fluctuate.
As a result, investors may want to change the composition of their EM
exposure depending on their market views. To make these decisions,
and identify which sub-asset class offers a better risk/return trade-off,
we look at a range of factors.
Firstly, we assess the fundamental global environment for the time
framework under consideration for the investment decision. Typically,
this means we will look well beyond our EM debt asset class to identify
the key developments shaping economic trends in the global economy.
Of particular interest are the global growth and inflation dynamics.
At the same time, we look at valuations from both an absolute
perspective, as well as relative to each other and relative to other
comparable assets. Finally, we consider technical factors such as
supply, flows, and risk appetite.
Annual returns: external debt vs local debt
25.7%
16.9%
11.7%
23.0%
10.7% 9.9%
6.3%
15.2%
6.3%
18.1%
-5.2%
28.2%
-10.9%
2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 YTD2012
22.0%
15.7%
12.0%
8.5%
-1.8%
EMBIG
GBI-EM Global Div*
18.5%
16.8%
3.3%
0.5%
* Unhedged in USD. Source: JP Morgan as at 30 April 2013

Emerging Market Debt
The impact of global growth
The rate of global economic growth is typically one factor which affects
both external and local assets. However, the difference between the
pace at which developed and emerging economies grow also has direct
implications for currencies which, after all, are priced in relative terms to
one another.
Monetary policy in developed countries is also important for multiple
reasons: interest rate differentials are pivotal for currency performance,
central bank management of expectations influences the term premium,
and continued supply of liquidity tends to trickle down and compress
risk premia.
In terms of sovereign creditworthiness, external debt assets are far more
sensitive to both levels and trends in credit ratings than local currency
assets simply because default episodes are more common in the former
than in the latter.
Countries need to secure access to foreign exchange before they can service
their external debt, while paying local debt is a matter of printing their own
currency. Finally, in assessing country-specific developments, the focus of
external debt is more on fiscal and external sector dynamics while for local
currency debt inflation and monetary policy are at the fore.
Valuations
In terms of valuing external debt, we look at absolute and relative valuations.
We believe that both the level of yields and spreads are relevant when
assessing the attractiveness of sovereign credit. We compare the trend
of spreads vis-à-vis the estimated risk of default, but also on a cross-asset
perspective. In other words, how does the risk premium offered by
EM sovereigns compare to similarly-rated assets: US investment grade
corporates or US high yield, for example.
The challenge of assessing valuations is compounded by the fact that
over the past few years the Federal Reserve has intervened decisively in
the US Treasury market, in an attempt to lower long rates to stimulate
economic growth. This means that the entire valuation exercise hinges
on a view of a heavily manipulated market (US Treasuries) with diminishing
levels of float.
As for local currency debt, the short-ends of the curves are anchored
by expectations of monetary policy, but long-ends embed multiple
premia: inflation (the flip side to the central bank’s credibility), term and
risk. Term premium is in most cases mean-reverting, but risk premium is
the one we care most about when assessing valuation. We look at this
on a relative basis to the premia observed in other risky assets, including
external debt. Correlation analysis gives us a good idea of how much of
the total premium is actually risk, simply by comparing its performance
over periods of time where volatility of risky assets is high.
When looking at foreign exchange valuations, we consider the following
approaches: real effective exchange rates, which track multilateral
exchange rates (typically trade-weighted baskets) adjusted for the
differential rates of inflation; current-account balance equilibrium
approaches, which essentially reverse-engineers the nominal exchange
rate that would achieve equilibrium in external accounts; and other
broader, more complex, models that account for relative changes
in total factor productivity.

First State Investments
Emerging Market Debt
Selected EM currencies real effective exchange rates
(source: BIS, as at 30 April 2013)
150
140
130
120
110
100
90
80
70
60
50
2007 2008 2009 2010 2011 2012 2013
Note: All exchange rates are rebased to 100 at Jan 2007.
Source: Bank of International Settlements as at 30 April 2013
Mexico
Brazil
South Africa
Hungary
Korea
Indonesia
You would expect technical factors to be specific to each asset class.
For example, supply dynamics are different for each sub asset class,
as are positioning and reflows. In external debt we work with an issuance
forecast derived from the financial requirements of sovereigns and
corporates and a schedule of coupon and principal repayments based
on outstanding debt. In this regard, we bear in mind the ‘scarcity’ value
being created by the decision of some EM governments to reduce their
external debt to GDP ratios. In local markets, supply is more predictable,
with most governments holding regular auctions.
Demand, on the other hand, is quite volatile and varied: local banks, financial
institutions and pension funds are structural buyers of local debt, while
foreigners are typically more opportunistic. It should be noted, though,
that as domestic debt markets evolve they are increasingly included in
global bond indices and enjoy a more predictable foreign demand from
index investors. In foreign exchange, we keep an eye on cross-border
mergers and acquisitions, initial public offerings of considerable size, and
performance of equity markets. We monitor central bank activity and
regulations governing repatriation of foreign exchange or other forms of
capital controls. From the dealer community we get an idea of relevant
levels for speculators (stops, barriers) and hedgers (importers, exporters,
and gamma position of dealers).
External debt and local currency debt in emerging countries share a good
deal of their fundamental underpinning, but given returns have different
drivers, their performance over the business cycle can vary quite substantially.
Understanding what those performance drivers are and monitoring them
consistently over time is at the heart of our investment process.
Wholesale Business Development
Telephone
Email
Graham Fox Head of UK & European Wholesale +44 (0)20 7332 6530 graham.fox@firststate.co.uk
Marc Bishop Sales Director, Europe and Third Party Distribution +44 (0)20 7332 6556 marc.bishop@firststate.co.uk
Carol Cunningham Sales Director, North of England & Ireland +44 (0)1606 883064 carol.cunningham@firststate.co.uk
Tom Burton Associate Sales Director, South of England, Channel Islands +44 (0)20 7332 6559 tom.burton@firststate.co.uk
Eva von Sydow Sales Director, Europe +33 (1)7302 46 74 eva.vonsydow@firststate.co.uk
David Gaschik Sales Manager, Europe +49 (0)69 7104 56302 david.gaschik@firststate.co.uk
Institutional Relationship Management
Telephone
Email
Fraser Wood Head of Institutional Relationships, EMEA +44 (0)131 473 2529 fraser.wood@firststate.co.uk
Chris Gower Head of Consultant Relationships EMEA +44 (0)20 7332 6869 chris.gower@firststate.co.uk
Ali Karmali Head of Middle East & Africa +44 (0)20 7332 6595 ali.karmali@firststate.co.uk
Alice Franks Senior Relationship Manager +44 (0)20 7332 6509 alice.franks@firststate.co.uk
Matt Savage Senior Relationship Manager +44 (0)131 473 2264 matt.savage@firststate.co.uk
Alex Mackenzie-
Smith Business Development Director +44 (0)131 473 2261 alex.mackenzie-smith@firststate.co.uk
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