>The “Great Risk Shift” – or why it may be time to re-think the developed-/emerging-markets distinction (DEUTSCHE MARKETS)

After defaulting on their external loans during the 1980s, many emerging markets (EM) experienced often severe financial crises during the second half of the 1990s and in the early 2000s. Most top-tier EM have weathered the global crisis much better in terms of public-debt sustainability and the short/medium-term growth outlook than many developed markets (DM). Following what may in the future be remembered as the “great risk shift”, it may be time to re-think old labels and traditional distinctions – and established views of economic and financial risk.

The term “emerging economies” seems to have been coined sometime during the 1980s and became part of standard vocabulary during the 1990s. The term referred to economies that were neither “developing” nor “developed”. In practice, it referred to a group of upper-middle-income countries that attracted private capital following the first oil shock. After defaulting on their external loans during the 1980s, many of the emerging markets (EM), as they were soon called by Wall Street and the City, experienced often severe financial crisis during the second half of the 1990s and in the early 2000s. To be fair, developed economies also experienced various crises during that period (e.g. ERM crises) and a handful of EM reached per income levels comparable with, or even higher than, some of the developed markets (DM), which is why the IMF moved these countries into the “newly industrialised economies” (NIE) category. But the pun about the “submerging” emerging markets, for better or worse, continued to stick.

Following the 2008 crisis, the financial fortunes of DM and EM diverged rapidly. While many DM are witnessing rapidly rising public debt, large fiscal deficits and slower growth, most toptier EM weathered the global crisis much better in terms of public-debt sustainability and the short/medium-term growth outlook. The diverging fortunes have been reflected most strikingly in the concerns about debt sustainability in the so called Eurozone PIIGS. For instance, investment-grade Greece 5Y CDSs are currently trading at 280 bp vs sub-investmentgrade Indonesia and Turkey at 160 bp.

The rating agencies rated Greece A until very recently, while both Indonesia and Turkey carry a sub-investment-grade rating. The rating agencies rationalize this in various ways. Sovereign ratings assess creditworthiness “through” the cycle. Typically, the investor base in the DM is much broader, domestically and internationally. Capital markets are much deeper, and their sovereign debt structures are often (though by no means always) less vulnerable than in the average EM. Finally, DM debt service track records are typically very strong. While some of these arguments have some merit, the rating agencies almost certainly underestimate the improvement in the creditworthiness of EM sovereigns and potentially underestimate the deterioration in DM creditworthiness.

Past (surprise) EM crises seem to have made the agencies cautious about EM upgrades. At the same time, the agencies tend to be reluctant to downgrade a country by more than 1-2 notches a year given that they claim to rate “through” the cycle. Another problem is that by downgrading a sovereign aggressively the agencies may contribute to financing difficulties and thus trigger a sort of “self-fulfilling prophecy”. The reluctance to aggressively downgrade a DM in line with the markets’ assessment of sovereign default risk is therefore understandable, but it hardly justifies the fact that until very recently Greece and China carried pretty much the same long-term foreign currency ratings. It looks odd that Greece with very limited macroeconomic flexibility due to EMU membership and a public debt burden exceeding 100% of GDP should be rated at the same level as China whose public debt amounts to a mere 25% of GDP and whose FX reserves exceed 45% of GDP.

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