Although emerging markets have not felt the recent financial market turbulence as much as developed economies have, some emerging market countries may be vulnerable to a decision by investors to pull back capital, the IMF said in its Global Financial Stability Report (GFSR). This vulnerability may continue after funding problems in more mature markets subside, the twice-yearly report said.
Overall, emerging market risks are balanced between slightly lower sovereign risks because of their generally good economic fundamentals and “rising risks in some economies experiencing rapid credit growth and increasing reliance on flows from international capital markets.”
Reflecting the same weakening in credit discipline that has led to problems in mature markets, “private sector borrowers in certain emerging markets are adopting relatively risky strategies to raise financing. Most noticeably, in some countries in Eastern Europe and Central Asia, banks are increasingly using capital markets to help finance credit growth,” the report, released on September 24, said.
Although the indicators suggest that banking systems in emerging markets are profitable and well capitalized, and have diverse sources of earnings and sound asset quality, credit issues “warrant increased surveillance as circumstances vary considerably across countries. Authorities in some emerging markets need to ensure vulnerabilities do not build to more systemic levels.”
The GFSR highlights areas that warrant increased surveillance in some emerging markets:
• The growing market for privately placed syndicated loans for corporations that in some cases “may allow issuers to avoid the more extensive disclosures required by public listings.” In some cases, credit discipline appears to be declining, with weaker credits and more first-time issuers becoming involved in the high-yield debt market. The private placement market has grown rapidly in emerging Europe, the Middle East, Africa, and, to a lesser extent, Asia, “partly at the expense of public bond and equity markets.”
• Rapid domestic credit growth funded by foreign borrowing, mainly “in emerging Europe and central Asia, which now absorbs nearly half of all international bank and bond financing.” Foreign financing “has enabled banks to increase liabilities more rapidly than the expansion of local deposits would allow,” but it puts at risk, especially, lower-rated banks “if appetite from international investors suddenly declines, potentially raising systemic risks for some banking systems.”
The report noted that international banks are often unwilling to lend to these banks through the interbank market because of the “difficulty of assessing their true financial condition” but that “these same banks can still issue international bonds, though the risk is reflected in wider spreads.”
• Increasing use of carry trade-style external borrowing and growing use of complex credit products, especially in Asia. For instance, some emerging Asian firms borrow in lower-yielding currencies, primarily the Japanese yen, which are a cheaper source of funding than what is available in local currency.
The search for higher returns has also led to growing issuance of complex credit products, such as structured and synthetic instruments, possibly exposing investors to greater volatility.
The report also explored foreign investment flows to emerging markets. It found that “contrary to what might be expected from reports of foreign investors crowding into small local markets,” there appears to be little effect on equity prices from activities of institutional investors, such as pension funds, mutual funds, and insurance companies, although there is evidence consistent with switching from one country to another within a region (herd behavior).
Hedge fund growth
Hedge funds and other highly leveraged pools of investment capital are becoming more active in emerging market countries. They have moved away from their traditional fixed-income instruments and are seeking other higher-yielding assets—in both equity markets and structured products.
Some are operating with a higher tolerance for risk and may raise important regulatory questions. But, the line between hedge funds and institutional investors appears to be blurring, with some investment horizons lengthening for hedge funds and narrowing for institutions.
One outcome of the strong investment in emerging market securities is the convergence of returns on mature market and emerging market investments. This “suggests that some global investors may be inclined to reassess the diversification benefits available from emerging market investments,” which also means that emerging markets behave more in line with mature markets “as the ‘cushion’ of excess returns is reduced.”
IMF Monetary and Capital Markets