Dr Nicholas Spiro of Spiro Sovereign Strategy -
Shortly after the 2008 global financial crisis erupted, many investment strategists argued that emerging markets (EMs) had become anchors of stability.
Untainted by the problems of sub-prime mortgages, financially stricken banks and heavy debt burdens plaguing many developed economies, EMs – which at that time were hauling the global economy back from the brink of an economic meltdown – were even perceived to have “decoupled” from Western economies.
But when the Eurozone crisis escalated dramatically in the second-half of 2011, the “decoupling” thesis was quickly debunked as investor sentiment towards mainstream EMs tracked the deterioration in market conditions in developed economies. In 2011, outflows from EM equity funds amounted to $46bn, compared with a record $96bn of inflows in 2010, according to data from JP Morgan.
Last year’s “taper tantrum,” triggered by the unexpected announcement by the US Federal Reserve in May 2013 that it planned to start scaling back its programme of quantitative easing (QE) was the final nail in the coffin for the “decoupling” thesis: outflows from EM equity funds last year totalled $26.7bn, according to JP Morgan.
Indeed EM equity funds are still suffering net redemptions this year despite enjoying huge inflows in the first-half of 2014 stemming from the significant improvement in sentiment towards EMs.
So when rating agency Moody’s Investors Service, in a note on September 30, referred to Poland – one of the largest EMs accounting for 10% of JP Morgan’s EM local currency government bond index (GBI-EM) – as a “safe haven,” there are plenty of grounds for scepticism.
To be fair, Moody’s treats Poland as a safe haven solely within the Emerging Europe region itself. Yet even this label doesn’t stand up to scrutiny.
The zloty has been one of the worst-performing EM currencies against the dollar of late, losing a whopping 10.5% since mid-July and 1.2% since the start of October. Polish shares have fallen 3.5% since the beginning of this month – a sharper decline than in Turkey and Russia, and significantly worse than the 0.8% fall for EM equities as a whole.
If a safe haven is an investment that retains its value or even increases its value in times of market turbulence, Polish assets hardly qualify on that score given their status – in particular the zloty – as a proxy for sentiment towards the Emerging Europe region as a result of Poland’s deep and liquid capital markets. Indeed over the past several years, Poland has become more sensitive to shifts in risk sentiment. In 2010, foreign investors accounted for some 20% of Poland’s local currency government debt market. Now, they hold more than 40% of Polish domestic bonds – one of the highest shares in EMs along with Hungary, Malaysia and Indonesia.
The Fed’s withdrawal of monetary stimulus and the persistent uncertainty about the timing and pace of US interest rate hikes have thrown the vulnerabilities of EMs into even sharper relief.
There are no safe havens in developing economies. There are, however, countries whose financial markets are more resilient than others, partly because of their stronger underlying fundamentals. Moody’s is right to attribute Poland’s relative resilience to the country’s “stable economic performance as well as its sound and predictable policy framework.”
Despite the high share of non-resident investors in Poland’s bond market, the yield on the country’s 10-year domestic debt currently stands at just below 3% – down from 4.75% at the end of January. Although the rally stems mainly from expectations that the European Central Bank (ECB) will eventually be forced to launch full-blown QE (and that Poland’s own central bank will once again trim interest rates, which is likely to happen at its next rate-setting meeting on October 8), Poland’s strong fundamentals ensure that its bond yields remain at relatively low levels during periods of financial market stress.
While the Czech Republic is the closest thing there is to a perceived “safe haven” in Emerging Europe, mainly because of the country’s modest debt levels, very low foreign currency-denominated debt and limited foreign participation in its domestic debt market (14%), Poland qualifies as one of the cleaner shirts in the dirty basket of developing and developed sovereign credits.
Playing in Poland’s favour is the persistently favourable view of the country in the eyes of investors. Poland has enjoyed good PR since the 2008 financial crisis erupted because of the country’s solid track record of growth – the nation’s positive growth rate at the height of the crisis in 2009 still figures prominently in articles about Poland in the financial media – and, more recently, the woes of Russia and Turkey which make Poland the only large market in Emerging Europe whose reputation is still intact.
In the realm of investor perceptions, Poland is one of the most successful EMs. Poland’s brand is strong and, for the time being, is helping mask many of the country’s domestic and external vulnerabilities.
This shows that the qualitative determinants of sovereign creditworthiness are just as important – if not more – as the quantitative ones in the minds of investors.
Nicholas Spiro is Managing Director of London-based Spiro Sovereign Strategy Ltd and a board member of Warsaw-based Lauressa Investments. Dr Spiro advises private and institutional clients on the idiosyncrasies of developed and emerging government debt markets and is an expert in central and east European affairs.
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