Liquidity crunch and emerging market crises

IN financial markets, very few things can be expected to repeat regularly like clockwork. Crisis periods in emerging markets (EM) are one such occurrence that we see every four to five years.

EM crises can also be once-in-a-lifetime opportunities. I witnessed this first-hand early in my career when one of my oldest clients, an experienced EM bond investor, put his whole portfolio into Russian bonds during the 1998 crisis, starting his purchases at 65 cents on the dollar, and continued buying every week all the way down. His last purchase was a 12.75 per cent coupon Russian government bond bought at 21 per cent that was just issued six months earlier at a full price of 100 per cent, as the country defaulted on its internal debt and announced capital controls.

Not knowing any better but feeling that I needed to communicate to him some kind of warning that he was losing a lot of money, he said: "Son, this kind of crisis will happen two or three times in your life. During calm markets, it is easy to quote Rothschild's "buy when there's blood in the streets", but as you can see, it's a whole different thing to actually do it in the middle of a crisis."

Five years later, Russia had fully recovered, and that 12.75 per cent bond rose from a low of 18 per cent all the way to 150 per cent , on top of interest received.

No financial adviser would ever recommend taking the kind of risks in the example above, but a lesson in how emerging market crises develop and pass is useful so that investors can have an idea of what to expect, even if they just watch from the sidelines.

EM crises have very similar beginnings and ends. At the beginning, we have a country whose economy has done well, leading to an increasing investor consensus for continued growth. This is accompanied by a narrative that things are finally changing for the better, often due to a new charismatic leader who will break with corruption and mismanagement of the past. As the upside profit potential begins to lure more investors, more facts are brought forward to justify the rise in that country's stock market (and often real estate and the improving credit ratings), such as its young and well-educated workforce that speaks English, the potential to become a new low-cost manufacturing base, or other similar arguments.

By now, the country itself has fully bought into the story of its own greatness. It is running both a fiscal and a current account deficit. While these deficits need to be funded by foreign money, this is not a problem as investors keep pouring in new money year after year. Any gaps in the deficits are covered by the issuance of new bonds in US dollars, growing the debt to GDP ratio, and increasing the reliance on a future stable currency exchange rate to eventually repay this debt.

If the above situation sounds all too familiar, it is because it happens over and over again. That country's stock market rises to 20x earnings, and its USD bonds pay only a small yield premium compared to much safer issuers.

Any time you see the same story unfold, it is wise to take a step back, or better yet, turn around and run.

Inevitably, a rude awakening derails the rosy predictions. Something happens that shakes investors' confidence, the currency starts to weaken, and investors begin to question the ability to repay all the debt issued, leading to a self-reinforcing downward spiral. Most often, the trigger event is a tightening of liquidity by the biggest provider of global liquidity, the US Federal Reserve. A cycle of interest rate hikes causes a stronger US dollar, making it more difficult for foreigners to repay their dollar debt. This is exactly the situation we are facing today.

Full-blown crises such as Russia in 1998 and the Asian crisis in 1997 are much deeper and more rare, culminating in actual default or near-default. Smaller EM crises are much more frequent. Russia had one in 2014 when it invaded Ukraine, and coupled with a plunge in oil prices, caused its bonds to fall by almost half. Brazil similarly had a crisis the following year as the president and much of her government was removed due to a corruption scandal linked to the country's largest oil company.

Every EM crisis causes an overshoot on the downside, as all the optimistic assumptions become clearly wrong. But then the adjustment starts. A rapid devaluation of the currency together with a drop in economic activity fixes the imbalances. Hyperinflation and default are always cited as risks of permanent loss during an EM crisis, but in reality, these negative outcomes occur far more rarely. In the majority of cases, the drop in the currency causes a fall in imports, reducing the trade deficit. Credit growth stalls, similarly reducing the country's current account imbalances.

A number of economic indicators linked to a country's money supply can be reliably used to assess when the worst of an EM crisis is over, which marks the bottom of the economic and investment cycle.

Participating in the recovery after a crisis event should only be attempted by experienced investors who know what to expect and can withstand the risks.

Argentina issued a 100-year bond just last year, taking advantage of demand among investors who ignored the country's history where it has been in default for much of the last half century. Last year's rosy outlook for that bond was broken in record time. Every investor would benefit from resisting the temptation to invest in an EM country when the future outlook is overly bullish.