An article in FT today “Original Sin in Emerging markets: It’s back” explains that the risk of lending in dollars to EM countries that earn in local currencies is increasing and is accidentally hidden by the nature of Central Bank record keeping. When an EM country borrower sets up a subsidiary in the Cayman Islands that confuses record keeping and makes it appear the EM country has less external debt. EM countries typically borrow in dollars and pay back the loan with local currency which is converted to dollars to make a semi-annual payment. Thus EM borrowers take on an extra layer of risk because when things go bad for their country’s economy the country needs to devalue, which is usually the single best and most expedient way to fix their problems. However, devaluing the currency makes it harder to payback debt since it may cost an extra 30% to 50% more in local currency to pay back dollar denominated debt.
This risk is a mirror image of a junk bond investor’s dilemma: The investor is taking the risk that he can temporarily own junk bonds to get the high yield with a plan to sell off junk bonds when the economy goes into recession to avoid loss of principal. The mirror image on the part of the EM borrower is that the borrower takes on risk that he can temporarily borrow in a junk bond like manner, by borrowing in dollars even though he intends to pay back the loan by earning local currency. In theory the borrower knows that during a crash he should try to pay off the dollar denominated debt by refinancing into a local currency bond, which is the mirror image of the investor who must dump his junk bonds when the economy goes into a recession. However an EM borrower may already be a “BB” grade (one notch below investment grade) during the high point of the EM country’s cycle, so during a crash it will be impossible to refinance into a local currency bond at precisely the moment that it is most needed.
Thus it is much less risky to be an owner of high quality domestic junk bonds than it is to be the borrower, since the investor has better chances to restructure his portfolio by simply selling bonds than the borrower has to refinance. The extra layer of risk that the borrower experiences means that the Sharpe ratio for such an investment is worse than for a domestic junk bond. EM bonds have four extra risks over domestic junk bonds: EM government law changes, EM currency devaluation making it harder for the borrower to pay the loan in dollars, generic “B” paper credit quality default risk and commodity based economy risk.
Many EM countries have a significant portion of GNP from commodity exporting. These industries have a decade long boom/bust cycle. When they crash, it may be difficult to stimulate other parts of the economy. The reduction in commodity exports means the flow of international funds into a country is reversed making its currency go down at precisely the time that the domestic economy is weakening. Then the EM government decides to devalue to help exports, but by then the EM debtors might face a near impossible task of converting devalued local currency into dollars to pay the international bonds.
The decade long term of a commodity boom creates a track record of a rising economy and a declining rate of debt defaults so that after five years the historical five and three year Sharpe ratios look excellent. This fools investors into lending money to EM countries near the top of the commodity cycle. A better way to invest in EM bonds would be to look at the worst case 20 year history and wait until the low point and then load up on distressed debt during a commodity-led crash.
“B” paper debt has a contingent characteristic of potentialy becoming a risky equity-like asset. With EM debt the risk of it morphing into a high risk equity (due to defaults) is greater than domestic junk bonds and thus an investor might as well simply buy EM equities if they really want to take on risk in that area.
Investors should seek independent financial advice about the risks of Emerging Market bonds.
I wrote an article “Hidden risk of EM debt”.