A Different Kind of Debt

We've written in the past about the positive structural forces at work in emerging markets. Deregulation, business friendly legislation, declining inflation, more developed infrastructure and stronger fiscal positions all argue for continued strength and resilience in the face of political uncertainty. We can now add a few more developments to the mix, both related to new types of debt and financing, further solidifying the case for global economic growth going forward.

Traditionally, emerging markets finance a large part public spending with US dollar-denominated debt. This was primarily due to very high or unpredictable inflation and unstable exchange rates, which forced emerging economies to issue bonds in more stable currencies. In recent years, however, both inflation and exchange rates have stabilized, opening the door for developing countries to issue sovereign debt in their own currencies. And that's precisely what they've been doing. According to a recent Economist article, dollar bonds now account for just 28% of emerging economies' outstanding debt.[1]

This is a positive development for a number of reasons. With mostly dollar-denominated debt on the books, currency crises precipitated debt crises, a vicious cycle that sent many a country plummeting into recession. But many countries now float their currencies on the open market to some extent and appear to have discarded the excessive spending in good times that eventually led to default. In addition, deeper local capital markets are being created, a systematic change that bodes well for the future.

On a more localized level, a new lending practice called micro-lending, or micro-credit, is gaining momentum. As we touched on in our February 16th commentary "Bottom Feeding," around four billion people live on $2 a day in the developing world. Because these people have such miniscule incomes and often lack steady employment and verifiable credit histories, they are not bankable to most lenders. Micro-lending is simply the practice of providing very small, or micro-sized loans, to this segment of the population. The concept received some legitimacy recently after its founder, Muhammad Yunus, was awarded the Nobel Peace Prize for 2006.

Access to credit is one of the fundamental pillars of economic growth, and micro-lending is a potentially powerful tool for the emerging markets. Not only does it help alleviate poverty by giving the poor a chance to establish sustainable means of income, but it also fosters innovation by providing capital to entrepreneurs who would otherwise be ignored by the larger financial system. To be sure, this is a very slow process. But eventually the increased disposable income and innovation fostered by micro-lending will lead to economic development and growth.

Emerging markets stocks have had a great run over the last several years, but we don't believe the party's over just yet. Strong economic headwinds are bolstering developing regions and positive fundamentals remain largely underappreciated. The recent developments of sovereign debt and micro-lending only add to the structural case for emerging markets.

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[1] "Bye-bye EMBI," The Economist, February 24, 2007