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The Danger in Emerging Market Debt

February 1, 2016
by Robert Huebscher

Most observers saw the recent troubles in the high-yield


markets – the gating of the Third Avenue and Stone Lion
funds – as a precursor to a junk-bond crisis. Instead,
investors should be focusing on a potentially bigger
problem, according to Russell Napier. Open-end mutual
funds holding emerging-market debt are at risk.

Napier is an independent strategist at and co-founder of


ERIC, an online platform for the sale of high-quality
individually priced investment research. He is the author
of “The Solid Ground,” a global macro report originally
published by CLSA and now published independently. He
is also the author of the recently published book,
Anatomy of the Bear: Lessons from Wall Street's four
great bottoms, which is available from the link on this
page.

Napier spoke at Societe Generale’s annual global strategy


conference in London on January 12.

The problem, according to Napier, is that capital does not


move in the global financial markets in the way that was envisioned in the Bretton Woods agreement.
Imbalances, created by quantitative easing (QE) by global central banks, are now being unwound. The
result will be highly unstable, and the consequences will be dire as mutual fund investors find that their
EM debt is not nearly as liquid as they thought.

Let’s look at why we don’t live in a Bretton Woods-world and what this means for the capital markets.

We are not in Bretton Woods any more

“We don’t have a fiat monetary system,” Napier said. “We are destroying the monetary base in the
emerging markets, particularly in China.”

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By that, Napier means the ability of central banks to create reserves through QE does not apply to
those countries operating exchange-rate management regimes – such as China. A country that
defends its exchange rate by selling dollar reserves and buying back its own currency has to effectively
destroy that local currency. This is the reverse of QE and it impacts, to a greater or lesser extent, all of
the emerging markets. That is not a fiat-money system and thus deflation is much more likely than the
consensus believes.

Today we don’t have flexible exchange rates, and EM countries – like China – have been permitted to
accumulate massive surpluses. Market forces are finally forcing those external surpluses to be
unwound and thus the pressure is on the EM to run ever-tighter monetary policy.

Napier cited three specific ways in which the current system differs from what was planned under
Bretton Woods.

Exchange rates are not all linked, as they should be under Bretton Woods. Thus, when an external
surplus shifts, say from China to the U.S., it does not enforce money-creation in the U.S. Instead, it
produces a rise in the dollar exchange rate. Under Bretton Woods, no such appreciation in the dollar
would have occurred; instead, money, in the form of bank reserves, would have been created in the
U.S. Today, the shift in the external surplus brings monetary tightening to China, without an offsetting
monetary easing in the U.S., as it would have done under Bretton Woods, where all exchange rates
were linked together.

A shift of capital from a managed- to the floating-exchange rate country destroys money in the
managed regime, but does not create it in the floating regime. This cannot be accurately described as a
global fiat-currency system. Deflation is thus much more likely than people assume.

Second, each country was able to choose its own exchange rate, instead of having it set by market
forces as planned under Bretton Woods. In 1994, China chose an artificially low exchange rate that
was extremely beneficial to it, which allowed it to accumulate “truly huge” imbalances in its capital and
current accounts, Napier said. Those huge external surpluses forced the creation of excessive
amounts of Chinese bank reserves and bank credit – and a particularly weak financial structure in
China, he said. Choosing such an extreme undervaluation would have been politically impossible under
Bretton Woods and thus financial systems did not become as “geared” as they should be and are
vulnerable crises in an economic downturn.

Napier called the third difference the “craziest.” The current system has developed to allow the free
movement of capital, he said. For example, a wealthy family in the U.S. might accumulate substantial
dollar assets. If it decides to invest in China, it would sell dollar-based assets and buy renminbi, which
in turn would become Chinese bank reserves. China would get the dollars and buy Treasury securities.
The problem, Napier said, is that the free-flow of capital has allowed a U.S. family to affect Chinese
monetary policy. The amount of money creation that is possible today was not conceived under Bretton
Woods, Napier said.

That is scary enough, but, according to Napier, the dire consequences come when things go the other
way and China and other EM countries need to sell Treasury securities.

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The trouble in emerging markets

Indeed, that is what is destabilizing the EM now – and the instability is rippling into the U.S. As global
economic growth has slowed, EM countries are selling Treasury holdings in order to prevent their
currencies from depreciating too rapidly. EM currencies, as a result, are more expensive than they
should be.

“Never buy emerging-market equities when they are cheap,” Napier said. “Only buy them when the
currency is cheap.” Until the currency is cheap, he said, monetary policy is likely to remain too tight
with negative impacts for asset prices.

A clear sign that EM currencies are too expensive, according to Napier, is that the dollar-reserves held
by EM central banks have been declining. That is a sign, he said, that there are more sellers than
buyers of those currencies.

You can see that in the graph below, which shows the decrease in China’s dollar reserves since the
start of 2014:

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Similar trends are evident in Brazil, Russia and most other EM countries. This is an objective sign that
EM countries are tightening monetary policy. Until those reserves stop decreasing and at least level off,
Napier warned that EM equities would be too expensive.

The fact that EM countries are selling dollar reserves is part of a broader policy of monetary tightening
in the EM. EM countries are raising interest rates in an effort to stave off inflation and prevent capital
outflows. Indeed, Napier presented data showing that local bond yields have been rising across the
EM.

EM exchange rates will continue to decline, Napier said, for two reasons. EM counties need to devalue
to support their export markets. More broadly, though, as China slows it will depress the prices of
globally traded goods and reinforce a deflationary environment across the globe. The damage this
decline in prices causes in other emerging markets will add to the deflationary pressure.

The most obvious and direct consequence will be in EM bonds. Napier said that approximately $1.2
trillion of EM bonds are held by retail investors (and a lot more is held by pension funds and other
institutions). At some stage, he said, redemptions will kick in and those investors will realize that “this
stuff is not liquid.”

Redemptions could be triggered by a major EM default, Napier said, which would cause those
investors to realize that the yield they expected on EM debt was unrealistically high.

To predict which countries are must likely to default, he said one could look at the Reinhart and Rogoff
research, which showed that countries with external indebtedness greater than 35% of GDP were
most vulnerable. The table below shows some of the countries that are most vulnerable:

Page 4, ©2018 Advisor Perspectives, Inc. All rights reserved.


An even more reliable predictor of default risk than the percentage of external indebtedness, he said,
was whether a country has defaulted previously, putting countries like Argentina and Russia in the
crosshairs.

The implications for U.S. investors

The gating of the Third Avenue and Stone Lion funds, Napier said, was similar to what happened to the
two BNP Paribas funds in August 2007. That was the seminal event that triggered the global financial
crisis. Napier said that the next crisis will be particularly painful for investors in mutual funds holding
EM debt.

But it’s not just those investors who are being impacted by events in the EM. EM central banks that are
selling Treasury bonds must have a counter-party buying those securities. Those buyers of Treasury
securities are selling corporate and high-yield bonds, which has driven up spreads in the corporate and
junk-bond market.

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“The savings system in the U.S. is realigning,” he said.

That is causing nominal and real yields to rise in the U.S. and other developed markets. It is most
evident in the spike in junk-bond spreads, he said, but yields in the short-end of the Treasury yield
curve have crept up since April 2015. At the same time, inflation has decreased – and Napier said the
CPI could decline by another 150 basis points. That deflation will be driven by weakness and falling
exchange rates in the EM.

There is also a risk in those developed-market banks, he said, that hold EM debt.

Beware of the $33.4 trillion in assets globally in open-end mutual funds, Napier said. That amount is
three-times the U.S. GDP, and much of it is invested in securities that are not as liquid as mutual-fund
investors expect.

Napier’s recommendations were to invest in long-dated U.S. Treasury bonds, gold (“soon,” he said),
and U.S. and Japanese equities.

Page 6, ©2018 Advisor Perspectives, Inc. All rights reserved.

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