Mexican Currency Crisis 1994

Mexican Currency Crisis 1994

Mexican Currency Crisis 1994

Posted on: February 18, 2012 - 11:43 pm
by Admin

By Dan Hallett, CFA, CFP

I was quoted in a recent Globe & Mail article warning that higher yields available in emerging markets bonds (compared to Canada bonds) come with additional risk.  Given that the investment fund industry has launched several emerging markets bond funds and exchange traded funds in recent years, it’s worth putting my comments and this growing class of funds into context.

Canada’s first generation EM bond funds

If memory serves, this latest string of emerging markets bond fund launches is round two for the Canadian investment industry.  When I started in the industry in 1994, emerging markets equities had just finished a year of triple-digit returns.  But unlike today’s focus on China and India, most of the enthusiasm back then zeroed in on Brazil and its Latin American counterparts.  Fidelity and Guardian were two sponsors of first generation emerging markets bond funds.

But a Mexican Peso crisis in late 1994 began a string of mid-late 1990s emerging markets currency crises.  They all put a dent in the market values of and infatuation with emerging markets bond (and equity) funds.

Fidelity Emerging Markets Bond Fund, for instance, was merged into its sibling, Fidelity American High Yield fund in 1999.  Similarly, Fidelity North American Income (sold by many advisors as a foreign money market fund) was merged into Fidelity Canadian Short-Term Bond after its big Peso sent the fund’s unit price southward.

Today’s EM bond funds – the pitch

Fast forward to today and there is a growing list of second-generation emerging markets bond mutual funds and ETFs.  And the sales pitch is striking a more sensitive chord today.  Developed countries the world over are up to their eyeballs in debt and sovereign default fears are abundant.  Emerging markets, on the other hand, sport skinnier debt-to-GDP ratios and are looked at as global economic saviours.  Accordingly, as developed nations are getting credit downgrades, emerging markets are being held out as safer credits.

But these supposedly safer credits are offering yields well in excess of bonds issued by more heavily-indebted developed nations.  Venezuela is an interesting example.  The country boasts a debt-to-GDP ratio of 39% and has seen GDP growth north of 4% year over year (according to www.TradingEconomics.com).

Yet 15-year Venezuelan bonds yield north of 12% annually according to Bloomberg.  Other Latin American government bonds yield 1 to 2 percentage points more than bonds issued by Canada, the U.S. and Germany.

Debt levels alone don’t predict emerging markets defaults

The sales pitch for emerging markets debt – like this one from RBC – might have us think that debt levels alone can be used to assess sovereign default risk.  But judging by the ‘spreads’ of emerging markets bond yields above developed world sovereign debt, the global bond market is saying that other important factors determine default risk.  Otherwise, emerging markets bonds would yield less than developed country debt.

In This Time is Different – Eight Centuries of Financial Folly, Carmen Reinhart and Kenneth Rogoff examined – among other things – a history of default among developing countries.  While high debt levels were universally linked to default episodes, the authors found that emerging markets defaults have generally occurred at debt levels that are generally considered ‘safe’ for more mature economies.

They found that nearly half of the three-dozen emerging country defaults between 1970 and 2008 occurred at debt-to-GNP ratios below 35 percent.  One recent illustration of this is Ecuador’s 2008 default which occurred at a debt-to-GNP ratio of 20 percent.

While developed countries tend to run a higher risk of default at debt-to-GNP ratios above 60%, history suggests that the danger zone for emerging markets typically starts at 35%.  While emerging markets countries boast lower overall debt levels, they also are less willing and less able to shoulder as much debt as their more developed peers.

Reinhart and Rogoff suggest that pinpointing any one country’s debt intolerance threshold (or where the risk of default rises significantly) may largely be a function of a country’s own history of default and inflation.  In other words, the global bond market and the credit default swap market generally consider emerging markets higher default risks for good reasons.

Including emerging markets debt in portfolios

Our firm has never explicitly included emerging markets debt as part of client portfolios.  Those who can’t resist the lure of this class of global bond should keep a few things in mind.

When determining allocation limits, include emerging markets bonds into the larger bucket of higher yield bonds.  Common guidelines limit high yield (and in this case emerging markets) bonds to between 33% and 50% of total bond exposure.  But for some investors the appropriate exposure might be zero.  Whatever the case, all investment policy guidelines should be driven by individual goals – which can’t be stressed enough.

Too many investors and their advisors will gravitate to emerging markets bonds because of the lure of the sales pitch and the returns in recent years.  Our approach is to build portfolios with ‘core’ and ‘enhancement’ building blocks.  We begin with ‘core’ exposure; and only when that is insufficient to achieve stated goals do we introduce ‘enhancement’ strategies – like higher yield bonds – to juice portfolio return potential.

Those simply chasing returns, however, tend to have unrealistic expectations – which is bound to end in disappointment.

 

The Mexican peso, whose devaluation in the December 1994 tequila crisis defined the EM traumas of the 1990’s, is one of Latin America’s bellwether currencies. Thanks to NAFTA and the factories on both sides of the Rio Grande, Mexico is leveraged to a strengthening US industrial and business cycle. I believe the Mexican peso is undervalued at current levels as the Hacienda (Mexico’s powerful monetary elite) is now committed to auction USD 400 million in cash whenever the MXN/dollar depreciates 2% from a prior fix in a classic managed float FX regime.

A stronger Mexico peso in 2012 will not surprise me as real GDP growth is accelerating, due to stronger domestic demand, high oil prices and exports. Inflation could rise as the weakness in the peso in 2H 2011 meant a higher cost for wheat (and tortillas!) and petrol. Yet Mexico, unlike India, faces no structural inflation dilemma.

Amazingly, in a nation once fabled for fiscal recklessness and serial sovereign defaults, Mexico’s fiscal deficit is a mere 0.5% of GDP. Mexico’s $14 billion FDI more than offsets its current account deficits, meaning hot money is not needed to finance its modest twin deficits, again unlike the Indian rupee and Turkish lira. In an ideal world, I would prefer to buy the Mexican peso at 14.30 for a eight month 12.40 target against the dollar. This is not the Panglossian best of all possible worlds. The Banco de Mexico is in hawkish anti-inflation pass through mode, an argument for a firmer bid in the peso.

Last week, I postulated that a yen depreciation against the dollar based on US Treasury JGB interest rate spreads was possible but even I was stunned by the speed at which the yen tanked on Wednesday against the buck, down almost to 78 (hedge funds, crowded trades, high octane daisy chains of leverage!). Of course, the yen was the top performing major currency last year against both the dollar and the Euro. But the game’s morphed, if not changed now.

The new embrace of risk in global market (the same week Greece effectively defaults, a sovereign rose by any other name stinks just as bad!). I believe the Japanese yen will revisit 82-85 far sooner than the FX markets thinks (or option skews suggest), I am naturally inclined to pair strong with weak so the Mexican peso against the Japanese yen is naturally a strategic FX trade whose metric are alluring.

This is the Tequila-Shogun FX trade! Of course, 2012 is an election year in Mexico, as was 1994 when Carlos Salinas devalued the peso and 1982 when Lopez Portillo defaulted on Mexican sovereign debt to Wall Street money centre banks. President Calderon’s term ends in July. So watch the Mexican peso like a hawk to generate money making mood swings.

The Mexican peso is the best performing EM currency against the US in 2012 for good reason. The peso benefits from the Bernanke Fed’s latest zero rate FOMC pledge till 2014. After all, offshore (mainly US) investors hold one third of the local peso bond market. I notice the yields on the Mexican Eurobond has tanked and Mexico’s sovereign CDS is now 145, the same as Abu Dhabi. The world’s smart money is eating some profitable burritos and enchiladas, amigos!
Matein Khalid