How an emerging-market trend may ease volatility - David Wessel

A decade ago, when financial crisis spread from Thailand to Indonesia to
Korea to Russia to Brazil, one common thread was that emerging-market
economies had done a lot of borrowing -- in dollars. Sharp declines in
their exchange rates increased the burden of paying back debts --
measured in baht, rupiah and won.
Painful tax increases, cuts in government spending, sharply higher
interest rates and corporate bankruptcies ensued.
Emerging-market countries' inability to borrow abroad in their own
currencies has been dubbed "original sin" by economists Barry
Eichengreen, Ricardo Hausmann and Urgo Panizza. They have argued it is a
major reason that developing-country economies are more volatile and
crisis-prone than the U.S., Europe and Japan, which long have borrowed
in their own currencies.
A lot has not changed in the past 10 years -- the tendency of investors
to assume that today's trends will continue indefinitely, for instance.
One thing that has changed is that emerging-market governments and
corporations increasingly are borrowing in their own currencies, and
that should make their economies more stable.
Emerging-market governments had $786 billion in home-currency debt
outstanding when the crisis hit in 1997. Last year, they had $3.15
trillion, according to the Bank for International Settlements, the
central bank for central bankers. Companies in those countries had $416
billion of home-currency debt in 1997; last year, they had $1.38
trillion.
A lot of those bonds are held by emerging-market citizens, who save in
the currency they earn. Available data reveal the currency in which debt
is denominated, not the nationality of the debt holder. But in the past
two years, foreign investors have become active buyers of local-currency
debt. J.P. Morgan Chase now calculates indexes for emerging-market debt
issued in local currencies; the market capitalization of such debt
available to foreign investors stood at $468 billion at the start of
2007 -- excluding China, India and others with capital controls or other
hurdles for foreign buyers.
WHY? And is this redemption from original sin? Or is it a passing moment
likely to vanish when financial-market sentiment shifts?
The fact that Poland and Brazil can borrow billions in zlotys and reals
reflects a confluence of forces.
Foreign investors traditionally feared that an inflation-prone debtor
could simply print more of its own currency if it had trouble paying its
debts, so they insisted on being paid back in dollars or euros. That's
still a risk, but low inflation rates around the world make it less of a
concern; the virulent high inflation rates that often triggered sharp
currency devaluations have vanished. And low interest rates in many
developed countries have led global investors to take more risk to get
higher hoped-for returns or borrow in low-rate countries like Japan and
invest in higher-rate emerging markets.
At the same time, financial markets have evolved. "The growth in
derivatives markets and credit-default swaps means that you can better
cover exchange-rate risk and credit-event risk [market jargon for
defaulting on debts] internationally than in the past," says Vincent
Truglia, who oversees sovereign risk ratings at Moody's Investors
Service.
And emerging-market economies are stronger. Their government budgets are
in better shape. Many are running trade surpluses. The move toward
flexible exchange rates has reduced the proclivity for economy-shaking
crises. Countries from South Africa to Mexico to the Philippines have
been buying back dollar-denominated debt and replacing it with
local-currency bonds. And their successful companies are getting better
at global finance.
From Wall Street to academia, there are differences on how much of this
reflects the kindness of global economic conditions and how much lasting
changes. "Perhaps the market may be a little exuberant," says University
of Chicago economist Raghuram Rajan, "but there are fundamentals that
have helped. When it's easy to borrow, easy to finance, these countries
look very healthy."
But some of this reflects structural changes that should withstand the
next economic storm. Joyce Chang, J.P. Morgan's head of emerging
markets, says flatly, "I don't think it's at all transitory." Among
other things, the rise of pension funds, insurance companies and mutual
funds in Latin America, Eastern Europe and Asia creates an appetite for
local-currency bonds. This growing base of local investors brings demand
and depth to markets that once had very little. That, in turn, makes
foreign investors more comfortable. Global financial markets won't
remain placid forever. Some emerging-market country will default, and
remind global investors that they aren't demanding enough for taking
risks. All investment fads end.
But some of the right lessons have been drawn from the 1997-98 crisis.
This is one of them. The eagerness and ability of emerging markets to
borrow in their own currencies makes life a little less treacherous for
the people who live in those countries. And that is a good thing.