Twenty years ago, few investors would have considered emerging market sovereign debt as a viable investment option. Political instability, social unrest, and economic turmoil were status quo for many emerging market countries. With upgraded infrastructure, stronger property rights laws, and increased political and economic stability, emerging market countries have grown tremendously over the last two decades. They currently account for two of the top five, four of the top ten, and eight of the top twenty countries by GDP.1
As emerging market economies have evolved, so have their credit markets. During a time of distress and negative real yields for many developed economies, this evolution has prompted investors to consider emerging market debt as an investment option that is not only viable but attractive. However, the first question facing an investor in emerging market sovereign debt is whether to invest in U.S. dollar denominated debt or local currency denominated debt. In this paper, we explore the differences between the two and describe the benefits that come with local currency emerging market sovereign debt. We will refer to emerging market sovereign local currency debt as “local currency debt” and emerging market sovereign U.S. dollar denominated debt as “USD debt”.
Local Currency Debt vs. USD Debt Issuance
International borrowers generally prefer to issue debt in their local currency rather than in U.S. dollars. Having a liability denominated in another currency can be disastrous if the issuer’s domestic economy suffers from inflation or undergoes currency devaluation, as Argentina did in the economic crisis of 1999-2002. Historically, issuing debt in U.S. dollars was the only option available to emerging market countries, because few investors were willing to bear the risks associated with investing in local currency debt. Now that their economies have become more stable, emerging market currency risk—which can, of course, be hedged—is somewhat less concerning. Indeed, given central banks’ efforts to significantly increase money supply in developed economies during the current economic cycle, the monetary discipline of central bankers in emerging markets challenge our previously held views regarding the relative risk of , emerging market currency vs. developed markets.
Figure 1 displays the amount of outstanding emerging market debt in U.S. dollars and local currency since 2001. The amount of outstanding debt issued in local currency has increased dramatically over that time, surpassing USD debt in 2005 and totaling over a trillion dollars as of March 31, 2013. The local currency debt market is now over twice the size of the USD debt market, with correspondingly greater liquidity and higher investment capacity.