The Danger In Emerging Market Debt

February 1, 2016

by Robert Huebscher

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Most observers saw the recent troubles in the high-yield markets – the gating of the Third Avenue and Stone Lion funds – as a precursor to a junk-bond crisis. Instead, investors should be focusing on a potentially bigger problem, according to Russell Napier. Open-end mutual funds holding emerging market debt are at risk.

Napier is an independent strategist at and co-founder of ERIC, an online platform for the sale of high-quality individually priced investment research. He is the author of “The Solid Ground,” a global macro report originally published by CLSA and now published independently. He is also the author of the recently published book, Anatomy of the Bear: Lessons from Wall Street’s four great bottoms, which is available from the link on this page.

Napier spoke at Societe Generale’s annual global strategy conference in London on January 12.

The problem, according to Napier, is that capital does not move in the global financial markets in the way that was envisioned in the Bretton Woods agreement. Imbalances, created by quantitative easing (QE) by global central banks, are now being unwound. The result will be highly unstable, and the consequences will be dire as mutual fund investors find that their emerging market debt is not nearly as liquid as they thought.

Let’s look at why we don’t live in a Bretton Woods-world and what this means for the capital markets.

We are not in Bretton Woods any more

“We don’t have a fiat monetary system,” Napier said. “We are destroying the monetary base in the emerging markets, particularly in China.”

By that, Napier means the ability of central banks to create reserves through QE does not apply to those countries operating exchange-rate management regimes – such as China. A country that defends its exchange rate by selling dollar reserves and buying back its own currency has to effectively destroy that local currency. This is the reverse of QE and it impacts, to a greater or lesser extent, all of the emerging markets. That is not a fiat-money system and thus deflation is much more likely than the consensus believes.

Today we don’t have flexible exchange rates, and EM countries – like China – have been permitted to accumulate massive surpluses. Market forces are finally forcing those external surpluses to be unwound and thus the pressure is on the EM to run ever-tighter monetary policy.

Napier cited three specific ways in which the current system differs from what was planned under Bretton Woods.

Exchange rates are not all linked, as they should be under Bretton Woods. Thus, when an extern surplus shifts, say from China to the U.S., it does not enforce money-creation in the U.S. Instead, it produces a rise in the dollar exchange rate. Under Bretton Woods, no such appreciation in the dollar would have occurred; instead, money, in the form of bank reserves, would have been created in the U.S. Today, the shift in the external surplus brings monetary tightening to China, without an offsetting monetary easing in the U.S., as it would have done under Bretton Woods, where all exchange rates were linked together.

A shift of capital from the managed- to the floating-exchange rate destroys money in the managed regime, but does not create it in the floating regime. This cannot be accurately described as a global fiat-currency system. Deflation is thus much more likely than people assume.

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Emerging Market Debt