Over two decades ago, economists Barry Eichengreen and Ricardo Hausmann shed light on the perilous practice of borrowing in foreign currencies among developing nations. This so-called "original sin" resulted in recurrent financial crises plaguing these countries for centuries. However, amidst this turmoil, a gradual transformation has taken place, particularly in countries like China, India, Brazil, Mexico, Chile, and Poland, as they diligently cultivated their local bond markets.
In a recent report by Goldman Sachs on "lessons from two decades of EM fixed income investing," it is revealed that EM local bonds have emerged as a formidable $7tn asset class, far surpassing the approximately $1.2tn EM dollar bond universe. This shift signifies a significant developmental milestone and showcases the resilience and drive of these emerging economies to establish self-sustaining financial systems.
Despite these advancements, disparities persist with smaller emerging markets continuing to rely on external borrowing due to their limited market size. Moreover, the increased international presence in local bond markets has shifted currency risks from borrowers to lenders, underscoring the ongoing challenges associated with financial stability.
Nonetheless, the evolution of local-currency EM bonds into a mature asset class is noteworthy. The once volatile and risky investment option has demonstrated remarkable resilience in weathering major global shocks over the past two decades. Notably, during periods when the Federal Reserve increased interest rates, EM fixed income holdings fared just as well, if not better, than developed market bonds.
Key Takeaways from Goldman Sachs’ Report:
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Lessons Learned from EM Fixed Income Performance:
- The EM fixed income landscape has matured, showcasing less outperformance but enhanced resilience in the face of economic turbulence.
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Macro/Market Environments Favorable to EM Fixed Income:
- EM debt offers high yields and positive cyclical exposure, making it an attractive investment option during periods of stable or easing rates and improved growth prospects.
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Role of EM Fixed Income in Portfolio Diversification:
- Hard currency EM bonds yield higher returns for portfolios with a higher risk tolerance, while local currency EM bonds provide differentiated risk exposure suitable even for low volatility portfolios.
- Managing Currency Risk in EM Fixed Income:
- Efficient management of FX risk is crucial for EM local debt investors, as complete hedging may limit cyclical upside potential at the expense of total returns.
As we reflect on the transformative journey of EM fixed income over the past two decades, we witness a remarkable maturation process that has not only broadened investment opportunities but also reinforced the resilience and adaptability of emerging markets. Looking ahead, continued vigilance and strategic risk management will be essential to navigate the evolving landscape of global finance with confidence and stability.
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