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Emerging market debt: are we likely to see another tantrum?


Will the final act of the “Great Divide” between the Fed and the ECB result in a liquidity tantrum? The current bond environment is wholly extraordinary. Neither the recovery in rates nor the bond volatility inherent in a low-rate environment can quite account for it.

The specific nature of the European quantitative easing can be summed up in two points: negative risk-free rates across most of the yield curve and a severe liquidity shortage caused by an asset purchase programme expected to absorb 40% to 50% of Bund issues. This scenario is a source of risk for the emerging debt markets, mainly because emerging countries were and remain heavily impacted by the monetary policies of the world’s major central banks. The relative strength of the spreads on dollar-denominated debt seems to actually indicate that investors’ current unease is focused on foreign exchange. However, to ensure that spreads remain impervious to renewed European bond volatility, any shock that might result in surplus demand for US Treasury bonds should be avoided.





Emerging countries were and remain heavily impacted by the monetary policies of the main central banks in mature economies, the most recent examples being the taper and the dollar tantrums. However, it should be pointed out that foreign investors reacted differently as these two events unfolded. In fact, during the taper tantrum, investors seemed not to discriminate between emerging countries. Yet during the dollar tantrum, it seems that only particular emerging countries experienced smaller capital inflows, and even some capital outflows.

The risk of another round of stress remains. The divergent paths pursued by the ECB and the Fed are potentially destabilising for the emerging sovereign debt markets. The ECB’s quantitative easing programme is a fresh source of risk while the consequences of a potential Fed funds rate hike remain very hard to predict. In order to identify the potential impacts on emerging country capital flows arising from this very unusual environment, we firstly propose taking a retrospective look at the taper and the dollar tantrums using an approach that allows us to categorise the different emerging countries on the basis of their fundamental characteristics.

Secondly, we will highlight the aspects specific to Europe that are fuelling current bond volatility.

Emerging economies can be categorised into four different groups

We have introduced a basic scoring system whose methodology is detailed in the box below.

Fundamental scoring methodology for emerging countries

In order to provide a typology of emerging countries based on fundamental criteria, we have developed a scoring system for 20 countries classified as emerging economies1 in the main indices for equities (MSCI) and bonds (EMBI). We added 11 developed countries for comparison purposes. Our procedure consists of two steps.

Step one involves assigning a score for 14 quarterly macroeconomic variables, which we grouped into four distinct categories:

Macroeconomic outlook: real GDP growth and inflation (YoY % change);

Debt: government debt, government deficit, gross external debt (% of GDP) and short-term gross external debt (% of gross external debt);

Investment and savings: current balance, change in current balance, gross domestic savings and change in gross domestic savings (% of GDP);

Vulnerability: currency reserves (months of imports), basic balance2, trend changes in domestic credit (% of GDP) and M2 money supply (% of FX reserves).


From a practical standpoint, on each date, for each country and for each variable, we subtract the average of the 31 countries studied. Then, we attribute a score represented by an integer between -2 and 2 based on each quintile of the distribution. For example, China’s real GDP growth in Q1 2015 was 7% YoY and therefore falls under the final quintile of the distribution. Therefore, we attribute it a score of 2.

Step two involves grouping the countries according to the scores obtained. To do so, we use a hierarchical ascendant classification (HAC) method. HAC presupposes a measure of dissimilarity among the individual items (in this case, the scores), which is grouped iteratively to obtain the different uniform classes. This process can be represented visually using a dendrogram.

1 Emerging Asia: China, India, Indonesia, Malaysia, the Philippines, South Korea, Taiwan and Thailand; Latin America: Brazil, Colombia, Chile, Mexico and Peru; Emerging Europe and Africa: the Czech Republic, Hungary, Poland, Romania, Russia, South Africa and Turkey. 
2 The basic balance is an alternative approach that helps determine the long-term trend in the balance of payments. It comprises the current account, net FDI and portfolio investments.

Once sorted into an ascending hierarchical classification, the 20 emerging countries of our sample can be broken down into four different groups: China and its partners, economies with a need to diversify their offer, Central Europe and the most fragile economies.

The first group is comprised of the major emerging countries of Asia (China, South Korea, Malaysia, the Philippines, Taiwan and Thailand). This group is made up of surplus economies. The current accounts of these economies stand on average at 6% of GDP; the latter has been strengthened in large part by lower imports. As surplus economies, these countries have had low borrowing requirements over the years and, as a consequence, their stock of public debt is relatively low. It now stands at 37% of GDP compared to an average of 62% for the sample. By contrast, the indebtedness of private players is fairly high since the stock of private debt (households + corporations) stands at 142% of GDP vs. the sample’s average of 126%. External debt, i.e. public or private debt denominated in non-national currencies, remains at low levels: 35% of GDP vs. an overall average of 103%. However, it is predominately made up of short-term debt (46% compared to about one third on average for all the countries in our sample).

The second group is made up of countries in need of diversifying their offer (Chile, Colombia, India, Indonesia, Peru, Czech Republic and Russia). In this group we make a distinction between the economies that export commodities, which include the economies of Latin America such as Chile, Colombia and Peru on the one hand and Russia and Indonesia on the other. In addition, this second group includes countries such as India or the Czech Republic, with the latter being highly dependent on the automotive sector. They are not all deficit economies. Colombia and Peru have the highest current account deficits (more than 4% of GDP) while India and Indonesia are running a current account deficit of between 1% and 2% of GDP.

Their level of gross savings is fairly low and declining further. On average, it is close to 20% of GDP, with the exception of Indonesia and the Czech Republic, where the gross savings rate is about 30% of GDP.

The third group is made up of three Emerging Europe countries (Hungary, Poland and Romania). This group is more uniform relative to the previous ones because their economies have a low savings ratio, a balanced current account (a very high surplus in Hungary), and a level of external debt relative to GDP along the lines of 88% on average, which is double the average for the emerging economies in our sample.

Finally, the fourth and last group is made up of so-called fragile economies (South Africa, Brazil, Mexico and Turkey). This is an identifiable group. These economies have the most deteriorated savings/investment balances (worsening current accounts, general government balances in deficit and lower gross savings). These economies can also be characterised by their need to refocus their growth models, now based on domestic demand, toward a model that is more investment-driven.

The “taper tantrum” will result in a massive capital outflow

As we emphasised, two significant events in the last two years caused turmoil in the bond markets of emerging countries. They left their marks on the dynamics of bond portfolio flows.

The first of these events occurred on 22 May 2013 when Ben Bernanke, the then Fed Chairman, gave a speech announcing the gradual phase-out of the Fed’s last QE programme, which increased uncertainty in every financial centre around the world. One of the notable impacts of the Fed’s tapering was a massive outflow of foreign capital from emerging bond markets.

These outflows took place without any discrimination or selectivity within all four groups described above. This round of capital outflows from emerging markets began very suddenly in early May 2013 and ended in March 2014. The impact of this sudden stop was disproportionate. The impact of the “taper tantrum” speaks for itself since, on average, about 35% of the stock of bond investments acquired pre-tapering1 were sold off.

In contrast, the dollar tantrum was more discriminating

In a second phase, the dollar appreciated very rapidly against almost every other currency as a result of the historic divergence between the monetary policies of the Fed and the ECB. The former announced its intention to gradually return to a conventional policy while the latter strengthened its non-standard tools by launching a QE programme. The period referred to as the dollar tantrum, when the real effective exchange rate of the dollar appreciated nearly 13% and almost 30% against the euro, ran from July 2014 to the first quarter of 2015.

From the standpoint of portfolio bond flows, our four peer groups were impacted fairly differently. In fact, compared to the stock of bond investments in our portfolios purchased during the pre-tapering phase - hence before the first bout of stress -, the reduction in stock was only 2.7% for the Chinese bloc but 7% for the Emerging Europe group and 10% for the group made up of the most fragile emerging countries. The only group that saw its stock of portfolio bond investments replenished, with an increase of nearly 5% for this period, was the one made up of economies in need of diversifying their offer. That being said, on closer inspection it should be stressed that this increase is mainly due to heavy capital inflows into the Indian bond market. This predilection for India should be seen in the context of the coming into office of Narendra Modi, who was then credited with having a genuine capacity for reform.

The risk of another bout of stress for emerging debt cannot be discounted

Will the final act of the divergence between the Fed and the ECB end with a liquidity tantrum, during which the bond markets could be destabilised by a systemic bond market liquidity shortage? A QE programme fundamentally aims at changing market liquidity into monetary liquidity to support domestic demand. Thus, the surplus demand linked to QE can have a significant impact on the liquidity of certain bond segments.

Instruments such as the Bund or Treasury bonds are central to portfolio building since they are negatively correlated to credit assets (emerging country sovereign or corporate debt). Should risk premia linked to bond volatility form in European and US yields, it will lead to an automatic increase in the correlation between yields and credit assets. Ultimately, the appetite for the riskiest credit assets, such as emerging debt, could drastically diminish.

The current bond situation is wholly extraordinary. The specific nature of the European quantitative easing stems from the severe liquidity shortage caused by an asset purchase programme that is expected to absorb 40 to 50% of Bund issues and from negative rates across most of the yield curve.

It is important to bear in mind that the recovery of risk-free interest rates is a movement that was seen each time the Federal Reserve launched one of its asset purchase programmes in the past five years. In all three cases, the increase in inflation expectations accounts for most of these rate movements. Higher interest rates confirm the effectiveness of the strategy as it aims at increasing inflation expectations and reallocating investor portfolios toward riskier assets. It was probably this movement that Mario Draghi was referring to during June’s monthly press conference, when he stated that investors should get used to periods of higher volatility.

Will the volatility of US Treasury bonds result in a resurgence of currency volatility?

In the context of European QE, the current rise in European rates is likely being fuelled more by the formation of a liquidity premium rather than by an increase in inflation expectations. This is notably confirmed by the fact that the rebound of medium-term break-even inflation rates is already a first sign pointing to a downturn.

The climate has turned less favourable for emerging country rates. Firstly, local rates are being hurt by investor fears of a resurgence of emerging currency volatility. Indeed, the resurgence of bond volatility, in particular US Treasury bond volatility, should lead to higher volatility in the currencies of advanced economies and emerging market economies alike. It is clear, therefore, that the Fed’s strategy will be crucial for avoiding a powerful comeback of emerging currency volatility. We are maintaining our scenario of a very gradual approach by the Fed. As a consequence of this, we expect emerging volatility to remain fairly limited.

The relative strength of the spreads on dollar-denominated debt seems to actually indicate that investors’ current unease is focused on foreign exchange. However, to ensure that spreads remain impervious to renewed European bond volatility, it is important to avoid any shock that might result in surplus demand for US Treasury bonds. On this score, the current environment remains difficult: the US economy is slowing down and China’s financial stability is deteriorating with soaring local equity markets.

Should another bout of stress occur, it is very likely to be the group of economies with the greatest need to diversify their offer that will feel the effects as well as the economies of Central Europe, which all have a very large stock of external debt.


1 The pre-tapering phase is defined as the period between January 2004 and May 2013.



The divergent paths pursued by the ECB and the Fed are potentially destabilising for the emerging sovereign debt markets





The 20 emerging countries of our sample can be broken down into four groups: China and its partners, economies with a need to diversity their offer, Central Europe and the most fragile economies









The current bond situation is wholly extraordinary. Neither the trademark recovery in rates nor the bond volatility inherent in a low-rate environment can quite account for it








The current rise in European rates is likely being fuelled more by the formation of a liquidity premium rather than by an increase in inflation expectations





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Cross Asset of June 2015 in English

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BEN ABDALLAH Marc-Ali , Senior Analyst, Investment Solutions
HERVE Karine , Emerging Markets Senior Economist
MOUSSAVI Julien , Strategy and Economic Research at Amundi
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Emerging market debt: are we likely to see another tantrum?
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