Emerging markets (EM) capital markets have been through a revolution in the last decade as their local bond markets are increasingly hooked up to the international financial system, bringing in billions of dollars in fresh financing. But the coronavirus (COVID-19) pandemic and rising political and economic risks in some markets have seen these investors turn tail and flee for the first time in what could be a growing problem for governments struggling to fund budgets bloated by anti-crisis spending.
Fixed income investors have had a volatile year. After a very good first two months, the world went crazy at the end of February as first the coronavirus infections began to spread rapidly around the world and then in the first week of March Russia walked out of the OPEC+ production cut deal on March 6, sending oil prices crashing. A massive sell-off in EM securities quickly followed, from which markets have since recovered only part of the ground lost.
“Capital outflows in March were larger than anything seen previously but flows shifted positive starting in April. However, the rebound in flows is modest relative to outsized outflows earlier in the year. EM fiscal positions were hit hard by the crisis too,” report Sergei Lanau and Jonathon Fortum, economists with the Institute of International Finance (IIF).
For governments that have become increasingly dependent on that new money in local debt markets, revenue slumped just as crisis-fighting spending ballooned.
The upshot is governments are still issuing debt, but now risk “crowding out” borrowing by the private sector, which also needs to raise money; there are simply too many bonds chasing too few investors.
“In countries like India and South Africa, we highlighted the risk that increased sales of government bonds to the local financial system cause crowding out of lending to the private sector,” say Lanau and Fortum. “It is the first time we see widespread outflows from this asset class, as events such as the taper tantrum did not cause significant ructions in this market segment.”
However, the effects vary considerably depending on the financial health of the issuers. Countries like Colombia and Indonesia offset weak flows to local bonds issuing internationally but others like South Africa and especially Turkey, which has seen the worst outflows, suffered large net losses of foreign funding to the government.
Arguably already in a currency crisis after the lira broke through the psychologically important TRY7.5 to the dollar last week, the share of non-resident investors – excluding domestic banks’ foreign branches – in Turkey’s overall outstanding Eurobond stock fell to below 50% for the first time since January 2017, central bank data showed on September 17. And its domestic debt market has also been hit.
There has also been significant outflows from Ukraine’s Ministry of Finance hryvnia-denominated OVDP domestic bond market, which was only hooked up to the international settlements and payment system Clearstream last April. Including Ukraine into the system caused a revolution, with some $5bn of new money quickly flowing into the market. But since the February sell-off began non-resident investors have been selling off their holdings steadily at a time where the government has been forced to massively increase its borrowing. To make things worse, Ukraine’s Stand-by Arrangement (SBA) with the International Monetary Fund (IMF) is in danger as its partners worry about Ukrainian President Volodymyr Zelenskiy backsliding on the reform agenda. It seems increasingly unlikely that Ukraine will get its next tranche of IMF money this year, which it badly needs to meet its international debt obligations, while issues on the domestic market will also come in under par.
Russia has also seen a slowdown in inbound investment into its Ministry of Finance ruble-denominated OFZ treasury bills. However, after a mild sell-off during the depths of the crisis months, the market has stabilised as the summer comes to an end. The Russian Ministry of Finance has just passed a new budget that calls for borrowing to be dramatically increased from just under 15% of GDP to around 20% of GDP.
Investors continue to put money in Russian sovereign bonds despite the threat of sanctions and while markets like Turkey and Ukraine are seeing sell-offs, Russia continues to see inflows, albeit very modest amounts.
Russia's share of JPMorgan's GBI-EM index, the main global benchmark for emerging market local currency bonds, has grown to 8.3%, up from around 7% two years ago and just 1.5% in 2007, according to the latest data.
Analysts say that the country's well over half a trillion dollars' worth of reserves, a competent central bank and conservative fiscal policy make Russia one of the strongest markets, bulletproof to all but the worst-case sanctions. They told Reuters that the new sanctions threats related to events in Belarus and the ongoing problems in Ukraine won't dent the appeal of decent 2% 'real' interest rates (rates minus inflation) and one of strongest public balance sheets in the world.
Nevertheless, Russia continues to take knocks above and beyond those associated with the coronavirus. Talk about the EU abandoning the Nord Stream 2 gas pipeline after the scandal of anti-corruption blogger and opposition activist Alexei Navalny’s poisoning with Novichok, combined with falling oil prices and looming US elections, knocked 5% to 12% off the value of Russia's ruble in the first weeks of September, hurting the government bond and equity markets.
But that has to be set against the “amazing levitating ruble” that bne IntelliNews reported on in May that has decoupled to a big extent from oil prices as the fall in oil prices was largely offset by the inflows by foreign investors into the local bond market.
Even after the recent outflows the JP Morgan data showed that its clients were more invested in Russian bonds coming into the current events than at any time in at least the last six years. Foreigners owned a record 35% of the ruble-denominated OFZ bond market before the COVID-19 outbreak, which has fallen to 29.8% as of August, but the total outstanding non-resident position is still RUB3,053bn ($40bn), ahead of the RUB2,870bn they owned at the start of this year.
Thanks to its rock solid fundamentals and Central Bank of Russia (CBR) governor Elvira Nabiullina’s reputation as the most conservative central banker in the world, Russia’s debt market is one of the most attractive EM bond markets out there. Russia has also benefited from the general trend of investors moving away from dollar- and euro-denominated issues as investors become keener on the local currency issues that add an element of foreign exchange gains to earnings from just the coupon rates.
“Investor interest in local EM bonds increased substantially since the global financial crisis, coinciding with a trend toward less FX bond issuance,” the IIF economists say.
Still, in general the IIF reports that the outflow from local EM debt is the first significant outflow since investment in local EM debt took off in the last few years.
“The taper tantrum and the China devaluation scare of 2015 did not affect foreign bond holdings as severely as COVID-19. The global financial crisis was a shock of comparable magnitude but of more limited implications because foreign holdings were generally low to start with,” the IIF says, referring to the taper tantrum 2013 collective panic that triggered a spike in US Treasury yields, after investors learned that the Federal Reserve was slowly putting the brakes on its quantitative easing (QE) programme.