The Global Financial Crisis has impacted the way in which we interpret sovereign risk. Many developed countries are in unchartered waters with respect to unconventional monetary policies, extended balance sheets and public debt. With households and corporates in the developed world undergoing a painful de-leveraging process, emerging market countries in a lot of cases have shrugged off the crisis and are well above pre-crisis levels of output.

According to the IMF, emerging economies are predicted to grow at between 6-8% over the next 5 years, whilst advanced economies will have sub-par growth between 1-3%. In this environment, we don’t believe that the emerging country business model of pegging interest rates to the US Federal Reserve is sustainable in the future. We are predicting an era of currency appreciation in a number of emerging market countries.

Consider China, although introducing some policies to try and curtail credit expansion such as their major bank’s lending ratio requirements, the incentive to borrow money at low rates and invest in other asset classes is intense. This combined with an artificially high demand for exports due to their interest rate pegging policy is overheating the Chinese economy. As things stand, we believe the Chinese policy makers will need to make a choice between inflation or currency appreciation. We believe a methodical approach to allowing currency appreciation will be the most likely outcome.

The challenges ahead for advanced economies are substantial. Government debt is at its highest level in peace times, muted growth is expected as households de-leverage and then there is the demographic challenge related to the retirement of the baby boomers. This ageing of the population will lead to a substantial increase in the ratio of 65 plus year olds compared to those of working age. In terms of orders of magnitude, the IMF have calculated that the net present value related to the government costs of counteracting the Global Crisis are a mere 8.5% of the costs attributed to the ageing of the population. It is difficult to assess how prepared governments are for these costs, but we can determine that the impact of the Financial Crisis has made the starting point more difficult.

Challenges exist for emerging countries as well, but a lot was learned from the Asian Crisis in 1997/1998. Emerging countries, particularly in Asia have built substantial foreign currency reserves over the last 10-15 years and in many ways could be described as the world’s creditors. Developed countries on the other hand, could be described as the world’s debtors if we could perceive of a global balance sheet. Emerging countries are exhibiting far more promising economic fundamentals with improved growth prospects. It is these economic fundamentals that form the basis for our Local Currency Emerging Debt Strategy at Lombard Odier.


Emerging countries local debt capital markets have been growing substantially over the last 10 years and now represent USD 6.7 trillion. Together with USD 1.2 trillion of emerging hard currency debt, it is estimated that emerging markets now represent approximately 20% of the global bond market.

In our view, a number of balanced portfolios have a structural under allocation to local emerging market debt and their currencies.

Author:

Stephane Monier, CFA
Head of Fixed Income and Currencies
Lombard Odier Investment Managers