Source: Deutsche Bank Research

Deutsche Bank says after defaulting on their external loans during the 1980s, many emerging markets (EM) experienced often severe financial crises during the second half of the 1990s and in the early 2000s. Most top-tier EMs have weathered the global crisis much better in terms of public-debt sustainability and the short/medium-term growth outlook than many developed markets (DM).

Following what may in the future be remembered as the “great risk shift”, DB says it may be time to re-think old labels and traditional distinctions - - and established views of economic and financial risk. Deutsche Bank economist, Markus Jaeger, says the term “emerging economies” seems to have been coined sometime during the 1980s and became part of standard vocabulary during the 1990s.

The term referred to economies that were neither “developing” nor “developed”. In practice, it referred to a group of upper-middle-income countries that attracted private capital following the first oil shock. After defaulting on their external loans during the 1980s, many of the emerging markets (EM), as they were soon called by Wall Street and the City, experienced often severe financial crises during the second half of the 1990s and in the early 2000s. To be fair, developed economies also experienced various crises during that period (e.g. Sterling's ERM crises) and a handful of EMs reached per income levels comparable with, or even higher than, some of the developed markets (DM), which is why the IMF moved these countries, such as South Korea and Singapore, into the “newly industrialised economies” (NIE) category. But the pun about the “submerging” emerging markets, for better or worse, continued to stick.

Jaeger says following the 2008 crisis, the financial fortunes of DMs and EMs diverged rapidly. While many DMs are witnessing rapidly rising public debt, large fiscal deficits and slower growth, most top-tier EMs weathered the global crisis much better in terms of public-debt sustainability and the short/medium-term growth outlook. The diverging fortunes have been reflected most strikingly in the concerns about debt sustainability in the so-called Eurozone PIIGS. For instance, investment-grade Greece 5Y CDSs (currency default swaps) are currently trading at 280 basis points (2.8%) vs sub-investment-grade Indonesia and Turkey at 160 basis points.

The rating agencies rated Greece A until very recently, while both Indonesia and Turkey carry a sub-investment-grade rating. The rating agencies rationalize this in various ways. Sovereign ratings assess creditworthiness “through” the cycle. Typically, the investor base in the DM is much broader, domestically and internationally. Capital markets are much deeper, and their sovereign debt structures are often (though by no means always) less vulnerable than in the average EM. Finally, DM debt service track records are typically very strong. While some of these arguments have some merit, the rating agencies almost certainly underestimate the improvement in the creditworthiness of EM sovereigns and potentially underestimate the deterioration in DM creditworthiness.

The economist says past (surprise) EM crises seem to have made the agencies cautious about EM upgrades. At the same time, the agencies tend to be reluctant to downgrade a country by more than 1-2 notches a year given that they claim to rate “through” the cycle. Another problem is that by downgrading a sovereign aggressively the agencies may contribute to financing difficulties and thus trigger a sort of “self-fulfilling prophecy”. The reluctance to aggressively downgrade a DM in line with the markets’ assessment of sovereign default risk is therefore understandable, but it hardly justifies the fact that until very recently Greece and China carried pretty much the same long-term foreign currency ratings. Jaeger says it looks odd that Greece with very limited macroeconomic flexibility due to EMU membership and a public debt burden exceeding 100% of GDP should be rated at the same level as China whose public debt amounts to a mere 25% of GDP and whose FX reserves exceed 45% of GDP.

Source: Deutsche Bank Research

Jaeger says this raises another important point. Not only have the agencies insufficiently taken into account the improvement in EM credit metrics, but they seem to have paid insufficient attention to the qualitative improvement in EM macroeconomic management. A typical, top-tier EM today has “excess” FX reserves and does not suffer anymore from “foreign currency mismatches”, which were at the epicenter of virtually every EM crisis of the past 15 years. Most EMs are also net external creditors. This has allowed the EMs to overcome the “fear of floating” and adopt more flexible exchange rate arrangements, making them far less vulnerable to balance-of-payments shocks. Meanwhile, the EMs that do maintain rigid exchange rate regimes have more than sufficient FX reserves to back them up (e.g. China, Malaysia). The EMs, by and large, have also strengthened their commitment to public debt sustainability - - for the most part, they already have low public debt ratios. Last but not least, many EMs have independent central banks, which has instilled greater confidence in economic stability and sharply diminished traditional concerns about “fiscal dominance”.

Markus Jaeger says as the 2008 crisis has shown, EMs may still experience significant economic and financial volatility on account of large capital in/outflows and increased trade openness. Nonetheless, the likelihood of a (systemically destabilizing) sovereign debt crisis over the coming years in a major EM is much smaller than it was in the past. Perhaps the greatest “known unknown” in this equation is political risk. Ian Bremmer from Eurasia Group has defined an EM as a “country where politics matter at least as much as economics to the market”. The top-10 emerging markets do, arguably, face higher average levels of political risk, both domestic and external, than the DMs. Naturally, it is always possible to come up with a political event that could throw a country into political chaos and economic turmoil. Maybe this sort of “tail risk” or low probability/high impact risk, or call it what you will, justifies keeping EM credit ratings at levels below the DM, even if they have credit metrics comparable to DM. Nonetheless, in order to justify this difference, it would be helpful if the agencies provided an analysis of how the actualization of political risk would affect a government’s debt-servicing capacity - - in both DM and EM.

Jaeger says in summary, the distinction between EM-DM obscures more than it enlightens. When the world’s major economies were the largest economies with the highest degree of financial stability, the strongest external financial position (at least vis-à-vis less developed countries) and the highest per capita incomes, this distinction may have made sense. But following what may be in the future be recalled as the “great risk shift” regarding “developed” and “emerging economies”, it may be time to re-think old labels and traditional distinctions - - and established views of economic and financial risk.

SEE: Finfacts article, Feb 2010; The EMU and the PIGS or PIIGS to the slaughter