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The wider consequences of Greece’s tragedy

Finance Blogger: Ian Fraser Ian Fraser

It’s time that institutional investors woke up to the wider repercussions of the Greek tragedy and rethought their attitudes to risk as well as their approaches to asset allocation.

Obviously investors are aware of the way in which the credit crisis has accelerated the shift in the balance of economic power from the developed and towards the emerging world, a shift that has been influenced by the fiscal irresponsibility of the former. But they seem oblivious to the ramifications for risk.

Traditionally, emerging market sovereign debt has commanded a premium – known to the investment community as “a higher spread”—to the bonds issued by supposed “risk-free” countries such as the UK which traditionally have been able to borrow more cheaply thanks to triple-A ratings from the likes of Standard & Poor’s.

The situation historically arose because the perceived risk of a default by emerging market economies was so much greater than that in places such as the UK.

It clearly didn’t help that fixed-income investors had had their fingers burnt so often by feckless governments in emerging markets. Memories of the notorious emerging market defaults, such as those of Argentina (1982, 1989–1990, 2002–04), Brazil (1986–87, 1990), Nigeria (1996–88, 1992, 2002), and Russia (1998–99), take a while to fade.

Well, one might have thought that the European sovereign debt crisis, which prompted fears of possible defaults and repricing of debt issued by developed countries—with the so-called “PIIGS,” Portugal, Ireland, Italy, Greece, and Spain, seen as the most likely candidates—coupled with fears for the future of the euro itself really ought to have turned such cozy assumptions on their head.

Jerome Booth, head of research at Ashmore Investment Management, which specializes in emerging market debt funds, is surprised the aftershocks of the credit crisis, including the current sovereign debt crisis, have not caused institutional investors to reassess their attitudes to risk.

He believes that many institutional investors are today making flawed assumptions about the comparative riskiness of developed and emerging market economies, arguing it is time they recalibrated their perceptions of risk as well as rethought how they allocate assets.

He believes that institutional investors’ avoidance of uncertainty in favor of risk has tended to push them towards “easier-to understand randomness.” Rather than focus on political risk, and specifically on sovereign default risk, he believes they have tended to obsess about more quantifiable areas such as US and European corporate default risk.

“The essence of an emerging market is one where risk is perceived to be high and therefore priced in,” said Booth. “The credit crunch is a process which is having a leveling impact, as all assets are increasingly being seen with their risks better exposed.”

The concept of a “spread” means the additional yield above the so-called “risk-free rate.” But Booth believes that the risk of default from emerging market sovereign borrowers is today very similar—and, in some cases, is actually less—than from the supposedly “risk-free” countries. He said the “risk-free rate” is, in any case, a fiction and can in fact be more volatile than the credit which trades above it.

Supply and demand also have an impact on spreads too. The supply of fixed-income paper will rise, but most of the new issuance is going to come from countries in the more economically challenged developed world. Booth suggests this too will push emerging debt prices higher, and spreads lower.

Most European and US-based institutional investors remain significantly underweight in emerging market asset classes, even before the logic of GDP weighting for global asset allocation is taken into account.

Yet emerging markets are unlikely to assume the mantle of being “risk-free” from the developed nations—at least not in the short to medium term. There will also always be spasmodic areas of concern from particular markets.

Witness the recent panic over a possible default by Dubai World—which correctly sparked fears of sovereign defaults from elsewhere. Overall, however, it seems that investor attitudes are stuck in the past—even though this past is rapidly receding in their rear view mirrors.

As Mohamed El-Erian, CEO and CIO of Boston-based bond investors PIMCO, recently wrote: “What is transpiring in Greece is part of a much broader and profound theme that is slowly being appreciated by investors around the world: sovereign balance sheets are now in play as the global economy resets.”

Further reading for asset allocation risk



Tags: emerging markets , financial crisis , fixed-income investors , global imbalances , Greece , institutional investors , risk , sovereign debt
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