GLOBAL - Emerging economies would face a systemic crisis if foreign investors, who own one-third of EM local currency debt markets, begin to pull out their cash, fund managers have warned.
Michael Riddell, manager of M&G’s Emerging Markets Bond fund, said earlier this year the market “must be smoking crack” to perceive EM debt as a safe haven. Now he fears an unwinding of the huge positions foreign investors have placed in EMD will result in a “systemic event” for emerging market economies.
“A reversal of the huge capital inflows into EM debt would result in a total lack of liquidity and significantly higher borrowing costs for emerging market countries,” he said.
“It will not be just the EM sovereigns that have come to rely on these capital flows and the cheap financing this entails; EM banks and, to a lesser extent, corporates are probably in a similar position.”
Flows into EMD have increased over the past decade, with retail funds popping up in response to appetite.
In the IMA Global Bond sector alone, £7.3bn ($11.3bn) is invested in emerging markets funds, while Riddell pointed out foreign investors own 30% of local currency bonds in emerging markets.
“There are a handful of enormous global bond investors with heavy exposure to local currency emerging market debt, with some owning over 50% of individual EM sovereign bond issues. If the end investor wants to sell, the fund has to sell, and what if there is no-one that wants to buy,” he said.
“EMD has never had to deal with huge outflows before – in 2009 the foreign ownership was not as large – and liquidity is completely drying up.”
Riddell said there are already signs of lower liquidity, with EM currencies plunging against the US dollar in recent weeks. Last Thursday alone the dollar rose 1.3% against the Mexican peso, 3.9% against the Chilean peso and 2.25% against the Colombian peso, according to Bloomberg.
PSigma’s Thomas Becket and David Coombs of Rathbones share Riddell’s fears EMD is a consensus trade which could be unwound very soon. They are either zero-weighted or underweight EMD as a result.
Becket, PSigma CIO, at PSigma, said the price falls seen in recent weeks could continue because of the narrow pool of investorss who own the debt.
“The ownership in EMD is quite concentrated and if this changes, due to the asset class being very illiquid, we could see a marked sell-off.”
Coombs, head of multi-asset investments, also has no exposure as the speed of flows into the asset class has led him to be cautious.
“We are not convinced spreads have widened enough to move back in. They have widened recently as US treasuries have performed well and yields are down, but this could reverse quite quickly,” he said.
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