The Evolution and Future of Emerging Markets Fixed Income: PIMCO
As the emerging markets (EM) fixed income asset class evolves, investors want to know which trends are lasting and which are fleeting. To that end, looking at the major inflection points over the history of the asset class can provide a useful perspective. One very relevant theme that emerges is: Innovation in the EM asset class has often
followed periods of global financial market volatility.
I. Development of emerging markets fixed income
Beginning of an EM external debt market
During the 1970s, most Latin American countries borrowed heavily from U.S. and European commercial banks to finance balance of payments and fiscal deficits. The banks were flush with deposits from the capital surpluses of oil-exporting nations and were faced with sluggish economies in much of the developed world due to two major energy shocks during the decade. Fueled by these loans, EM economies grew at a relatively robust pace. EM exchange rates were mostly fixed at the time and generally became overvalued as inflation in EM countries exceeded that of their trading partners.
In the early 1980s, an unprecedented sharp rise in U.S. policy rates made it difficult for EM countries to service their floating rate debt while a sharp global recession caused a collapse in oil and other commodity prices. A series of Latin American defaults and devaluations followed. In 1989, U.S. Treasury Secretary Nicholas Brady crafted a new way for developing countries to convert their rescheduled foreign bank loans into long-term bonds collateralized by zero coupon U.S. Treasuries. The Brady program involved a substantial amount of debt forgiveness, which helped EM countries regain their ability to service their debts. The issuance of these so-called “Brady bonds”
presented global investors with the first liquid, investable EM debt instruments. Until then, investors’ primary option for gaining exposure to these countries had been through equities.
Overview of the 1990s EM crises
While the Brady program allowed emerging markets to emerge from default, they remained financially vulnerable. They continued to have relatively high, though reduced, levels of debt, much of which was denominated in foreign currency.
Local domestic issues rarely had maturities longer than one year, with three to six months being the norm. This was partly due to a lack of investor confidence in EM countries’ ability to service longer-term debt; at the time, most EM countries had relatively short histories of credible central bank inflation fighting policies, which made investing in longer tenor local bonds seem risky.
Many EM countries ran large trade and current account deficits during this period. At the time, many people believed this was justifiable from a macroeconomic and developmental perspective, taking the view that countries at lower levels of per capita income should be borrowing to invest in their economies. The prevailing macroeconomic wisdom also held that fixed exchange rates provided an anchor for stability in emerging markets where fiscal and monetary policies had a short history in the wake of the 1980s debt crises.
Unfortunately, the combination of deficits and fixed exchange rates made EM countries highly dependent on foreign capital flows to finance the deficits. When endogenous or exogenous shocks eventually hit, capital flows into emerging markets threatened to rapidly reverse.
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