An Analysis of Local versus Hard Currency

March 2014

Emerging Markets Debt

First State Investments

Manuel Cañas, portfolio manager in the First State Emerging Markets Debt team, discusses the relative merits of local and hard currency debt.

External debt and local currency debt have a lot in common, with the return on both dependent on the EM (emerging market) risk premium. The historical yearly correlation of returns between the two is 0.79. If overall market conditions are conducive for risk-taking, the risk premia embedded in both external and local assets should compress.

However, some key drivers for EM external and local debt performance differ, which implies that over the course of the global business cycle, their respective expected return/risk profiles fluctuate.

As a result, investors may want to change the composition of their EM exposure depending on their market views. To make these decisions, and identify which sub-asset class offers a better risk/return trade-off, we look at a range of factors.

Firstly, we assess the fundamental global environment for the time framework under consideration for the investment decision. Typically, this means we will look well beyond our EM debt asset class to identify the key developments shaping economic trends in the global economy. Of particular interest are the global growth and inflation dynamics. At the same time, we look at valuations from both an absolute perspective, as well as relative to each other and relative to other comparable assets. Finally, we consider technical factors such as supply, flows, and risk appetite.

Annual returns: external debt vs local debtManuel is a Senior Portfolio Manager in First State Investments’ Emerging Markets Debt team, where he is responsible for researching the Latin American region. Before joining the company in November 2011, Manuel spent four years with ING Investment as Senior Investment Manager of Emerging Markets Debt funds and four years with the Central Bank of Argentina. He has a total of 15 years’ experience in emerging markets. A CFA charterholder, Manuel holds a Licentiate in Economics from the University of San Andrés. A native Spanish speaker, Manuel is also fluent in Portuguese.

Manuel Cañas – First State Emerging Markets Debt

Emerging Markets Debt

25.7%

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 YTD2012

23.0%

10.7%

6.3%

9.9%

15.2%

6.3%

18.1%

-10.9%

-5.2%

28.2%

22.0%

12.0%

15.7%

8.5%

-1.8%

18.5%

EMBIGGBI-EM Global Div*

16.8%

0.5% 3.3%

11.7%

16.9%

* Unhedged in USD. Source: JP Morgan as at 30 April 2013

Emerging Markets Debt

The impact of global growthThe rate of global economic growth is typically one factor which affects both external and local assets. However, the difference between the pace at which developed and emerging economies grow also has direct implications for currencies which, after all, are priced in relative terms to one another.

Monetary policy in developed countries is also important for multiple reasons: interest rate differentials are pivotal for currency performance, central bank management of expectations influences the term premium, and continued supply of liquidity tends to trickle down and compress risk premia.

In terms of sovereign creditworthiness, external debt assets are far more sensitive to both levels and trends in credit ratings than local currency assets simply because default episodes are more common in the former than in the latter.

Countries need to secure access to foreign exchange before they can service their external debt, while paying local debt is a matter of printing their own currency. Finally, in assessing country-specific developments, the focus of external debt is more on fiscal and external sector dynamics while for local currency debt inflation and monetary policy are at the fore.

Valuations In terms of valuing external debt, we look at absolute and relative valuations. We believe that both the level of yields and spreads are relevant when assessing the attractiveness of sovereign credit. We compare the trend of spreads vis-à-vis the estimated risk of default, but also on a cross-asset perspective. In other words, how does the risk premium offered by EM sovereigns compare to similarly-rated assets: US investment grade corporates or US high yield, for example.

The challenge of assessing valuations is compounded by the fact that over the past few years the Federal Reserve has intervened decisively in the US Treasury market, in an attempt to lower long rates to stimulate economic growth. This means that the entire valuation exercise hinges on a view of a heavily manipulated market (US Treasuries) with diminishing levels of float.

As for local currency debt, the short-ends of the curves are anchored by expectations of monetary policy, but long-ends embed multiple premia: inflation (the flip side to the central bank’s credibility), term and risk. Term premium is in most cases mean-reverting, but risk premium is the one we care most about when assessing valuation. We look at this on a relative basis to the premia observed in other risky assets, including external debt. Correlation analysis gives us a good idea of how much of the total premium is actually risk, simply by comparing its performance over periods of time where volatility of risky assets is high.

When looking at foreign exchange valuations, we consider the following approaches: real effective exchange rates, which track multilateral exchange rates (typically trade-weighted baskets) adjusted for the differential rates of inflation; current-account balance equilibrium approaches, which essentially reverse-engineers the nominal exchange rate that would achieve equilibrium in external accounts; and other broader, more complex, models that account for relative changes in total factor productivity.

First State Investments

You would expect technical factors to be specific to each asset class. For example, supply dynamics are different for each sub asset class, as are positioning and reflows. In external debt we work with an issuance forecast derived from the financial requirements of sovereigns and corporates and a schedule of coupon and principal repayments based on outstanding debt. In this regard, we bear in mind the ‘scarcity’ value being created by the decision of some EM governments to reduce their external debt to GDP ratios. In local markets, supply is more predictable, with most governments holding regular auctions.

Demand, on the other hand, is quite volatile and varied: local banks, financial institutions and pension funds are structural buyers of local debt, while foreigners are typically more opportunistic. It should be noted, though, that as domestic debt markets evolve they are increasingly included in global bond indices and enjoy a more predictable foreign demand from index investors. In foreign exchange, we keep an eye on cross-border mergers and acquisitions, initial public offerings of considerable size, and performance of equity markets. We monitor central bank activity and regulations governing repatriation of foreign exchange or other forms of capital controls. From the dealer community we get an idea of relevant levels for speculators (stops, barriers) and hedgers (importers, exporters, and gamma position of dealers).

External debt and local currency debt in emerging countries share a good deal of their fundamental underpinning, but given returns have different drivers, their performance over the business cycle can vary quite substantially. Understanding what those performance drivers are and monitoring them consistently over time is at the heart of our investment process.

Emerging Markets Debt

Selected EM currencies real effective exchange rates(source: BIS, as at 30 April 2013)

50

60

70

80

90

100

110

120

130

140

150

2007 2008 2009 2010 2011 2012 2013

Mexico

Brazil

South Africa

Hungary

Korea

Indonesia

Note: All exchange rates are rebased to 100 at Jan 2007.

Source: Bank of International Settlements as at 30 April 2013

Emerging Markets Debt

Disclaimer

The information contained within this document is generic in nature and does not contain or constitute investment or investment product advice. The information has been obtained from sources that First State Investments (“FSI”) believes to be reliable and accurate at the time of issue but no representation or warranty, expressed or implied, is made as to the fairness, accuracy, completeness or correctness of the information. Neither FSI, nor any of its associates, nor any director, officer or employee accepts any liability whatsoever for any loss arising directly or indirectly from any use of this document.

This document has been prepared for general information purpose. It does not purport to be comprehensive or to render special advice. The views expressed herein are the views of the writer at the time of issue and may change over time. This is not an offer document, and does not constitute an investment recommendation. No person should rely on the content and/or act on the basis of any matter contained in this document without obtaining specific professional advice.

The information in this document may not be reproduced in whole or in part or circulated without the prior consent of First State Investments. This document shall only be used and/or received in accordance with the applicable laws in the relevant jurisdiction.

In Hong Kong, this document is issued by First State Investments (Hong Kong) Limited and has not been reviewed by the Securities & Futures Commission in Hong Kong. In Singapore, this document is issued by First State Investments (Singapore) whose company registration number is 196900420D. First State Investments is a business name of First State Investments (Hong Kong) Limited. First State Investments (registration number 53236800B) is a business division of First State Investments (Singapore). The Securities and Futures Commission has not reviewed the contents of www.firststateinvestments.com.

AucklandKiwi Income Property TrustLevel 14, DLA Phillips Fox TowerNational Bank Centre 205 Queen StreetAucklandNew ZealandTelephone: +64 9 359 4000Facsimile: +64 9 359 3997Web: www.kipt.co.nz/contact-us

First State InvestmentsLevel 3, 33–45 Hurstmere RoadTakapunaAuckland 0622New ZealandTelephone: +64 9 448 4922Facsimile: +64 9 486 7131

EdinburghFirst State Investments Management (UK) Limited23 St Andrew SquareEdinburgh EH2 1BBUnited KingdomTelephone: +44 (0) 131 473 2200Facsimile: +44 (0) 131 473 2222

FrankfurtFirst State InvestmentsWesthafen TowerWesthafenplatz 160327 Frankfurt a.M.GermanyTelephone: +49 (0) 69 710456 – 302

Hong KongFirst State Investments (Hong Kong) LimitedLevel 6Three Exchange Square8 Connaught PlaceCentralHong KongTelephone: +852 2846 7555Facsimile: +852 2868 4742

JakartaPT First State Investments Indonesia29th FloorGedung Artha GrahaSudirman Central Business District Jl. Jend. Sudirman Kav. 52–53Jakarta 12190IndonesiaTelephone: +62 21 2935 3300Facsimile: +62 21 2935 3388

LondonFirst State Investments (UK) Limited 3rd Floor30 Cannon StreetLondon EC4M 6YQUnited KingdomTelephone: +44 (0) 20 7332 6500Facsimile: +44 (0) 20 7332 6501

Melbourne Colonial First State Global Asset ManagementLevel 18, Tower One, Collins Square727 Collins StreetMelbourne VIC 3008AustraliaTelephone: +61 3 8628 5600Facsimile: +61 3 8628 5608

New YorkFirst State Investments599 Lexington Avenue, 17th FloorNew YorkNew York 10022 United States of AmericaTelephone: +1 212 848 9200Facsimile: +1 212 336 7725

ParisFirst State Investments International Limited, Paris14, avenue d'Eylau75016 ParisFranceTelephone: +33 1 73 02 46 74

SingaporeFirst State Investments (Singapore)1 Temasek Avenue#17–01 Millenia TowerSingapore 039192SingaporeTelephone: +65 6538 0008Facsimile +65 6538 0800

SydneyColonial First State Global Asset ManagementDarling Park Tower 1201 Sussex StreetSydney NSW 2000AustraliaTelephone: +61 2 9303 3000Facsimile: +61 2 9303 3200

TokyoFirst State Investments (Japan) Limited8/F, Toranomon Waiko Building12–1, Toranomon 5-chomeMinato-kuTokyo 105-0001JapanTelephone: +81 3 5402 4831Facsimile: +81 3 5402 4839

Visit our website at www.firststateinvestments.com

Contact details