If you still have doubts whether or not there is a massive bubble in emerging financial markets, just look at the eurobond market. The JPMorgan EMBI+ index, which measures the risk premium on hard currency-denominated emerging market bonds, narrowed to 156 basis points (bps) in late April, or about a percentage point and a half. For the sake of comparison, just two years ago it measured twice as high, or over 3 percentage points — which was, incidentally, also a record low, having fallen by more than a full percentage point over the previous year.
Some individual countries have recorded even more spectacular progress. Look at Brazil, for example. In late 2002, Brazilian eurobonds yielded 22 percentage points more than comparable U.S. Treasuries. Now, barely five years later, the spread has narrowed to less than 1.5 percentage points.
True, the sovereign credit rating on Brazil has been upgraded steadily from deep into the speculative grade category — signifying a high probability of a sovereign debt default — to BB-plus. This is just one notch below the investment grade category, which opens the way for a large number of institutional bond investors to purchase Brazilian government bonds.
However, when Mexico’s credit rating finally reached investment grade five years ago, its bonds traded at 300 bps over Treasuries. Brazil’s spread is less than half that, even before it has reached investment grade.
The benchmark dollar-denominated Brazilian government eurobond due 2015 yielded just 87 bps above comparable U.S. Treasuries.
Reserves Build-UpThe spike in risk premium on Brazilian eurobonds in 2002 was a special case. It followed debt default by Argentina in late 2001, the world’s largest to date, which ended up penalizing foreign holders of Argentina’s government bonds. At the time, Brazil was also about to elect a leftist president, Luiz Inacio Lula da Silva, who investors feared could repudiate the country’s foreign debt.
In the event, even though Lula was indeed elected, he opted for market reforms, not the usual leftist prescriptions. Brazil has curbed fiscal spending and promoted pro-growth policies. As a result, the country has been enjoying a large trade surplus. This year alone Brazil has accumulated more than $35 billion in foreign reserves, bringing the total to more than $120 billion. Its government, only recently one of the heaviest debtors among emerging economies, has now become a net creditor to the rest of the world.
Hard currency reserves have been boosted around the world. In the early 1990s, Poland hoped to achieve currency stability by maintaining reserve holdings of around $3 billion. Now, even Russia, a financial basket case in the late 1990s, has central bank reserves worth well over $300 billion. It should be recalled that during the 1997-1998 Asian financial crisis only China and Taiwan were able to thwart currency speculators — largely because of their large reserve holdings.
Booming EquitiesBased on widely accepted investment theories, pension funds in developed economies should allocate a substantial portion of their portfolios to emerging market equities. The reasoning goes as follows: Companies in mature economies have only limited profit growth potential, whereas emerging economies should maintain generally faster growth rates — albeit coming from a low base — and their companies should have more rapid earnings growth over the longer term.
The only caveat has always been that with faster growth came greater volatility. Indeed, periodic panics and currency devaluations have regularly wiped out all the spectacular previous gains.
The world looks like a very different place now. Globalization has spurred U.S. and Western European multinationals, and they are now enjoying very rapid profit growth. At the same time, emerging financial markets in Latin America, Asia and Eastern Europe suddenly look far more stable, even as they still offer strong returns.