Emerging-market debt investors are ignoring red flags

This article was written by Lisa Abramowicz of Bloomberg Gadfly. It appeared first on the Bloomberg Terminal.

Everything is apparently fantastic in emerging economies.

That, at least, seems to be the view of investors who have been dumping cash into the bonds of these nations at an accelerating clip.

The optimism stems from a sudden belief that the world’s economy is poised to take off. Economists expect the U.S. to grow more quickly because of President Donald Trump’s policies of fewer taxes and regulations. And there’s less talk of Europe falling into a deflationary spiral.

This all helps developing economies, which have less debt relative to established countries and stand to benefit from faster growth. Emerging-market debt funds reported $7.4 billion of inflows so far this year, surpassing the combined flows into U.S. junk bonds and loans during the same period.

But investors are so eager to buy this debt that they’re disregarding an important gauge of these nations’ fundamental health: their foreign-currency reserves. And this measure is flashing red warning lights.

After decades of building up these cushions, emerging economies are starting to chip away at their hard-currency holdings to support their currencies and economies. About one-fifth of developing nations tracked by the International Monetary Fund now have an insufficient pool of these reserves to buffer against shocks, according to IMF standards, Bloomberg Intelligence’s Damian Sassower noted in a recent report. Emerging-market reserves have declined at a record pace of nearly 10 percent, to $7.3 trillion, since peaking at $8.1 trillion in 2014, Sassower said.

Consider South Africa, which has $166 billion of sovereign debt outstanding. It had only 87 percent of the reserves it needed under the IMF’s standards, which measure foreign-exchange holdings relative to export earnings, broad money supply and external liabilities. Turkey had only 91 percent of its recommended hard-currency assets, while Pakistan had only 73 percent, according to data through Oct. 3, 2016.

China, the world’s second-biggest economy, has been blowing through its foreign-currency reserves so quickly that it’s now on the brink of failing to meet the IMF’s standard, according to Bloomberg Intelligence’s Tom Orlik.

Foreign-currency reserves aren’t the only factor that investors ought to look at, but it’s an important one they shouldn’t ignore, either. Nations are facing a more difficult path going forward. While growth may pick up, it isn’t likely to return to boom days anytime soon. Trump’s trade policies are still unclear. Europe faces significant political risk.

And the fact that countries need to deplete their reserves shows that they’re facing real problems that need to be addressed. China, for example, has been liquidating its Treasury holdings to help support its currency while extending new credit at an unprecedented pace. That’s not a recipe for stability, especially considering that nations such as Malaysia and South Korea, which depend heavily on China, are also using up their reserves.

So far this year, investors seem to be just fine with the shrinking pool of foreign-exchange stockpiles. But they should be careful that they don’t wait too long before noticing when it’s too shallow.

This column does not necessarily reflect the opinion of Bloomberg LP and its owners.

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