By the end of that month, the S&P 500 had declined 3.1 percent after thrashing about violently for two weeks. Riskier markets were savaged as startled investors sought to salvage some of their gains. The flight to quality, triggered by rising interest rates in the G3 (dollar, euro and yen) currencies, pummeled emerging-market assets in particular. Morgan Stanley’s emerging-markets index, which had been up almost 20 percent for the year at the beginning of May, saw those gains erased and fell another 6 points by May 17. Foreign investors’ losses were exacerbated by sliding currencies. The Brazilian real, for example, fell more than 10 percent against the dollar that month.

Despite the upheaval, emerging-market debt investors and strategists remain cautiously bullish. Many of these countries, they say, have strong GDP and employment growth, and inflation is largely under control. One positive indication of their longer-term prospects is the emergence and success of what is, essentially, a new asset class: debt denominated in their local currencies. This is less exposed (from the issuers’ point of view) to the vicissitudes of G3 currency markets and is a bellwether of growing investor confidence in key emerging markets.

"I am bullish on the asset class over the medium and long term," says Francis Beddington, London-based head of research for Central, Eastern Europe, the Middle East and Africa at Standard Bank. "We see faster growth in these countries compared with the core [developed countries], and we will continue to do so."

Countries that have pursued successful fiscal and monetary reform are the most promising. "We fundamentally believe the outlook for local debt is good, and that really is a function of rate-cutting cycles around the emerging-market universe, particularly in countries like Brazil and Mexico," says Edwin Gutierrez, London-based portfolio manager in emerging-market debt at Aberdeen Asset Management.

Tequila Hangovers
One of the concerns voiced in May was that the emerging markets, after three years of double-digit growth, could be teetering on the edge of another widespread debt crisis of the sort that erased billions in investor capital in the mid and late 1990s. But the pressures that precipitated those crises are largely absent today.

AHEAD OF THE HERD 5-year average annual GDP growth
Country	Percent, 2000-2004
China	8.52
Russia	6.84
India	5.74
Korea	5.40
Thailand	5.06
Hong Kong SAR	4.78
Indonesia	4.62
Turkey	4.34
Philippines	4.26
Singapore	4.12
Average World GDP Growth	3.84
Source: Pimco; International Monetary Fund, World Economic Outlook Database, April 2005.

To see why, a bit of history is in order. Many of the emerging-market economies pursued expansionary fiscal and monetary policies in the 1980s and endured falling reserves, high inflation and overvalued currencies. Reforms in the 1990s—including privatization programs, better banking oversight, anti-inflationary monetary polices, financial market and trade liberalization and more responsible fiscal behavior—stabilized many of the leading economies in Latin America and Asia. But many who sought to control prices by pegging their currencies to the dollar courted trouble. The pegs resulted in the currencies becoming overvalued, and they eventually collapsed under the weight of speculative attacks. Most emerging-market debt was denominated in dollars, yen or one of the European currencies (since few investors were willing to take two exposures: to the fortunes of the issuer itself and to the strength of its currency), and the devaluations of the local currencies made servicing the foreign currency debt prohibitively expensive. Defaults ensued—in Mexico in late 1994 (the knock-on effect this had on other Latin debt was known among traders as the "tequila effect"), throughout Asia in 1997 and in Russia in 1998.

The aftermath, though extremely painful for citizens of the countries themselves, as well as for their foreign investors, was cathartic. "When these countries went from a pegged exchange rate to a floating exchange rate, these were dramatic events, and some countries defaulted. But once that happens and the currency can now move and adjust, the country is much more flexible and is able to undertake reforms it might not have been able to do in the past," explains John Peta, Boston-based emerging markets portfolio manager with Standish Mellon Asset Management.

In particular, the governments were now freed from the need to spend their reserves trying to shore up their pegs. They could pursue more rational, independent monetary policies. "For the most part, they are putting those reserves in the bank and either paying down debt or not issuing as much debt," Peta says. "It is the debt-to-GDP ratios that the rating agencies look at, so the credit ratings have been improving on emerging-market countries." The change has been dramatic: Roughly 40 percent of the JPMorgan Emerging Bond Index is now rated investment grade, whereas a decade ago only 3 percent could make such a boast.

This newfound credit quality and economic stability has allowed these countries to issue debt in their own currencies. "Emerging-market countries are slowly opening up their capital markets to foreign investors, presenting those investors with a whole new set of options that they can access easily," says Jim Barrineau, research analyst with investment company AllianceBernstein in New York.

TOP VIEW: The turmoil in emerging markets since the broad global sell off in mid-May has caused some to fear the three-year bull run in this sector is over. But emerging-market specialists believe many of these economies are strong enough to warrant investment in their domestic local-currency bond markets—a relatively new asset class that has evolved in line with the countries’ fiscal and monetary reforms. Investors must bear the local currency risk, but it may be worth it: These instruments are significantly outperforming dollar-denominated emerging-market debt.

Mexico is one example. In the decade following the peso crisis, Mexico tamed inflation and reduced domestic interest rates. This allowed it to extend its local currency yield curve; by the end of last year, it could issue debt with tenors out as far as 20 years. "Mexico has been a bit of a pioneer, but now more and more of these countries are trying to extend their yield curves," Peta says. Brazil is also.

Several factors are combining to improve the depth and liquidity of these local markets. Trading, clearance and settlement systems are being upgraded, while repo and derivatives markets are developing. Meanwhile, domestic institutional investors—insurance companies, pension funds and mutual funds—that need longer-dated local assets have emerged, providing another source of demand. "It’s an interesting dynamic, because we’re getting both the development of local bond markets from the issuer side and, at the same time, an expansion of the investor base, both offshore investors and local institutional investors," points out Rashique Rahman, head of emerging-markets fixed income strategy at HSBC in New York. "There doesn’t seem to be much sign of that turning around, despite the correction."

The Worm Has Turned
Professional investors refer to local currency-denominated emerging-market bonds as a new asset class in its own right because these investments have a completely different risk and return profile than equivalent dollar-denominated issues. Looking at Mexico again, 10-year local paper there, as Worth went to press, yielded around 9 percent, while the equivalent dollar-denominated debt yields were around 6.5 percent. Of course that means investors believe the former to be riskier than the latter. "You can think of the dollar bonds as pure country risk, and you can think of the local debt as country risk plus currency risk," Barrineau explains.

INTERNAL VS. EXTERNAL DEBT ISSUANCE
Country	2003 internal/total (%)	2004 internal/total (%)	2005 internal/total (%)	Total debt(US$bill)*
Argentina	8.2	8.2	9.1	77
Brazil	78.7	81.1	84.2	444
Colombia	65.7	69.8	73.5	49
Indonesia	100	98.1	96.1	51
Mexico	74.5	75.9	78.3	221
Peru	30	33.3	38.5	13
Philippines	58.5	56.8	54.3	57
Russia	20.8	32.8	35.5	62
South Africa	88.2	90.7	89.5	76
Turkey	84.8	85.9	86.1	218
TOTAL	69.4	72.2	75.5	1268
* As of June 30, 2005 Source: BIS

So those looking to local-currency bonds have to be happy bearing emerging-market currency risk. That type of bet did not look at all sound in May, when emerging-market currencies suffered. However, in the longer term, some professional investors believe this risk is worth taking. "I think it’s better to view the asset class right now less as a total return vehicle and more in relation to other fixed income asset classes," Barrineau argues. "In that context, it can still be an attractive investment, because you still have considerable spread over U.S. Treasuries." Barrineau believes the emerging-market currencies will not re-appreciate dramatically in the near term. "Export growth has slowed, and there is an atmosphere of general uncertainty in the market. But the well-run emerging-market countries, like Brazil and Mexico, I think, will stabilize at a lower level."

Clearly, the uncertainty over global growth prospects in the wake of G3 interest rate increases—the proximate cause of the broad sell off in May—and the fact that currency performance depends largely on governments adhering to sound policies, argues in favor of caution when evaluating these assets. Indeed, Teresa Kong, a senior portfolio manager with Barclays Global Investors in San Francisco, recommends that investors be much more selective when evaluating emerging-market credits. "I think we’ll see increased dispersion, where the market will start differentiating and assigning a higher risk premium to the countries that are going to suffer in a relatively more volatile environment," she says. "It’s probably a good time to reexamine what you have in your portfolio and, going forward with the backdrop of higher volatility and lower global liquidity, making sure you are long the right basket of securities."

One important indicator of issuing governments’ health is the status of their current account. Kong is wary of emerging-market countries that are running current account deficits, such as Turkey and Hungary. She is more optimistic about Latin American and Asian countries. Beddington agrees. "I think you avoid the current account deficits, and you look for current account surpluses," he says.

Those who wish to delegate this sort of analysis to specialist asset managers have a small but growing number of options. "In line with the development of the markets in general, we’re seeing EM local bond mutual funds that are global in nature being set up," says HSBC’s Rahman, although he notes that there are now only a handful of such funds.

John Ferry is a senior correspondent for Worth.

Art by Stephen Webster.

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