20th December 2012
Historically, it has been an easy distinction.Countries such as China or Brazil were considered emerging, while Spain, France or Italy were considered developed. Yet the credit crisis and its aftermath have disrupted the popular perception of what constitutes an emerging or developed market and there may be opportunities for investors as markets adjust to the new reality.
Increasingly, markets previously considered 'emerging' – notably Brazil, Turkey, India – are having their debt rated as 'investment grade' by groups such as Moody's, S&P and Fitch, while countries previously considered 'developed' are being downgraded to junk. Rather than being a binary 'emerging' versus 'developed' a number of countries are becoming a hybrid – nominally emerging, but with some of their debt rated as higher quality.
In many ways, this makes perfect sense. Emerging markets are often creditor nations, running current account surpluses. They are also growing faster. The rating agencies, which control the definition of what is technically an emerging or developed market, are generally considered to have been slow to downgrade troubled developed markets and to upgrade strong emerging markets (even Greece has not yet been downgraded by MSCI – as Bloomberg reports), but the trend is accelerating.
For example, the extent to which previously held views of emerging versus developed markets are shifting was shown by a recent Fitch Ratings report which said: "Credit quality showed divergent paths across emerging and developed markets. Downgrades trailed upgrades across the universe of Fitch-rated emerging market issuers while developed market issuers continued to see more downgrades than upgrades. Downgrades affected a modest 1.2% of emerging market issuers in the third quarter, below the group's upgrade rate of 2.3%. Across developed markets, the 4.2% share of issuers downgraded edged below the 4.9% recorded in the prior quarter but topped upgrades of 2.4%."
Turkey, India and Brazil all saw certain types of government bonds upgraded to 'investment grade' status by the rating agencies in 2011 while other countries such as the Philippines appeared to be on the right track reported here on Bloomberg,the Times of India and the website of the Philippines’ Department of Finance.
The agencies tend to upgrade the local-currency rating before any foreign-currency sovereign rating, but some countries, such as Brazil, have seen both types of debt upgraded. Equally, the rating agencies will tend to upgrade shorter-term debt before they upgrade long-term debt, but in some countries both have been upgraded.
The natural conclusion of the trend is clear. Eventually, weak growth in developed markets will see more countries fall to 'emerging' status, while strong growth and government finances will see more countries achieve 'developed' market status. If this is the case, investors will have to get used to Brazil or India as developed markets and Spain or Italy as emerging markets.
The issue is further complicated by the emergence of emerging market corporate debt as an asset class. These are corporate bonds from emerging market companies. Investors have shown increasing demand for this type of bond as returns from developed market corporate bonds have fallen. Although nominally an 'emerging market' asset class, around two-thirds of emerging market corporate debt is investment grade, according to emerging debt specialist Ashmore Investment.
The upgrades of government debt have an impact for the economies of the countries themselves. For example, in the Bloomberg article on Turkey, Ozgur Altug, chief economist at BGC Partners in Istanbul, says: “S&P’s upgrade may allow the Treasury to “issue long term lira-denominated eurobonds. Turkish companies would also have access to lira borrowing on international capital markets."
It means that emerging market governments and corporates have access to cheaper borrowing on capital markets. While debt has become a dirty word in the context of the excesses of Western governments, used prudently it can be a useful tool to facilitate growth in an economy.
However, before investors completely reappraise their view of emerging markets, it is important to stress that perception can take time to catch up. These markets – both equity and debt markets – are not as liquid and are still likely to suffer if there is widespread risk aversion among investors. Currency factors are also a consideration, although many investors believe that emerging markets currencies are undervalued and likely to appreciate – reported here on the Wall Street Journal.
The definition of emerging and developed markets is fluid, but the rating agencies can be slow to catch up with the new reality. This can offer opportunities for investors as markets may not yet reflect the real risk, or lack of risk in different markets.