Though developing economies have changed for the better, the benefits aren’t always convertible into dollars By Jon Sindreu Sept. 24, 2023 7:00 am ET 9 A financial crisis in Russia in 1998 spelled the end of Long-Term Capital Management. This is the second of three parts of a Heard on the Street series on the 25th anniversary of Long-Term Capital Management’s collapse. Emerging markets are in a much better place now than when Russian bonds sank Long-Term Capital Management a quarter-century ago. Emerging-market investments, not so much. Buying the local debt of developing-country governments and hedging out the foreign-exchange risk was among the most famous quantitative strategies deployed by LTCM. Although the 1990s was a period of constant currency crises—the Mexican “Tequila Crisis” in 1994, the Asian Financial Crisis in 1997—investors kept pouring money into emerging markets. Total return since the 2008 troughSource: JPMorgan (emerging markets), ICE Bank of America via FactSet (U.S.) EM local currencyEM hard currencyU.S. high yieldU.S. investment gradeEM local currency (dollarhedged)2009'10'15'20050100150200250300% It all unraveled when Russia defaulted on its ruble debt in August 1998. Collecting on hedges became impossible when counterparty banks shut down and the government froze ruble trading. What eventually spelled the end of John Meriwether’s hedge fund, though, was a flight to liquid assets that toppled other leveraged trades. Now, some fear a similar complacency. Emerging markets have done surprisingly well this year, despite what would normally be overwhelming headwinds such as high inflation, interest-rate increases by the U.S. Federal Reserve and a global economic slowdown. For doomsayers, China’s ongoing property crisis could play Russia’s role in 1998. The yuan is already at its weakest since 2007. A sudden depreciation seems unlikely, because the Chinese government and corporate sectors have ample reserves of dollars with which to support the exchange rate. But many analysts fear it might still happen and potentially trigger a painful stampede out of risky assets. Since LTCM's time, developingeconomies have become moreresilient...Top emerging economiesOfficial reserve assets '05'10'15'20200002.55.0$7.5trillion Currency regimeSources: International Monetary Fund (reserves), E.Ilzetzki, C. Reinhart and K. Rogoff, 2019 (regimes)Note: Includes the top-20 emerging economies Peg or currency boardCrawling pegManaged floatFloatOther'05'10'15199520000255075100% Recent crises in Turkey, Argentina, Sri Lanka and Ghana underscore the fragility of smaller nations with big debt piles. A lesson from the LTCM debacle was that even an apparently self-contained financial earthquake in one part of the world can wreak havoc on less-liquid investments everywhere. This time around, however, there are few signs of froth. Having been all the rage before the 2008 financial crisis, emerging markets have been a black spot in portfolios. Stocks have underperformed Western peers, while the JPMorgan GBI-EM Global Diversified Index that tracks domestic-currency bonds has returned a paltry 57%, even falling 5% over the past decade. Hedging the latter into dollars LTCM-style hasn’t fared much better. Meanwhile, debt issued by these countries in dollars has returned 142% since the 2008 trough—still far below the 240% gain generated by U.S. high-yield bonds. While net fund flows into emerging-market stocks have risen lately, data from EPFR shows that money continues to trickle out of both local-currency and hard-currency debt. And yet emerging markets have improved a lot in the past 25 years. They have curbed the old habit of relying on hard-currency debt that did so much damage back in the 1990s. Local-currency paper now makes up most of their bond markets. That might not fully insulate emerging markets from capital flights—during the onset of the pandemic, borrowing costs still shot up—but it helps pare blows. Their central banks also have become more effective at managing risks. During the Covid-19 crisis, emerging markets deployed quantitative easing to support domestic markets, and then got ahead of Western officials by raising rates as soon as global inflation jumped. That helps explain why local-currency bonds had an easier 2023: By getting painful rate increases out of the way, they escaped the Fed’s gravitational pull. Many big developing countries have moved away from currency pegs and crawling pegs, which set exchange rates between bands that change slowly. They have instead tended to embrace more malleable “managed float” regimes with flexible bands, data by economists Ethan Ilzetzki, Carmen Reinhart and Ken Rogoff show. Emerging markets have also built huge foreign-exchange reserves. Indeed, the likes of Brazil, Mexico and South Africa have shown far greater resilience after the pandemic than most analysts expected. It is only smaller “frontier” countries, as well as those with distinctive political situations such as China and Turkey, that have run into trouble. Still, global investors aren’t wrong to be wary. Rates of economic growth in middle-income countries have been on a downward trend, and the rewards of a better funding model are hard to reap. As Francesc Balcells, head of emerging-market debt at FIM Partners, points out, there is a paradox here: Weaker exchange rates have become both a cushion against financial crises and the key driver of poor performance for local-money debt. Yes, emerging markets’ greater resilience means that foreign investors should give them another chance. The irony is that most should probably stick to the old-school hard-currency bonds that issuers are better off eschewing: Within the JPMorgan EMBI Global Index, the investible universe has changed radically since 1998, becoming far more diversified and geared toward highly rated Gulf nations—with bulletproof balance sheets backed by oil—rather than the always-troubled Argentina. Or, perhaps, they can keep investing in rich countries with the peace of mind that developing markets probably won’t spark the next LTCM meltdown. https://www.wsj.com/finance/currenc...-burning-investors-89444ed1?mod=hp_lista_pos3 Better graphics if you use the link.