"When politics matters"

Unlike many traditional economies, with their middle of centre politicians and their independent central bankers, a change in government in an emerging market country can be a significant event. A general election in the UK or a presidential election in the US barely affects the markets these days. In fact, the markets are more concerned by a change in the make-up of the central banks. But even then, the reaction is muted. In reality, fiscal and monetary policy barely changes. Politics in emerging markets, however, can still cause a bit of a stir.

Before we look more closely at the political agenda over the next 12 months, let's take a look at how far emerging markets have come. The following chart shows the level of yields available from short-dated US dollar-denominated bonds. Improving credit quality together with a low level of yield in developed markets has led to most emerging market yields falling below 6%.

Only in the Ukraine and Argentina can you get yields still above 6% in US dollars. These low yields are forcing investors to look into the local markets. The next chart shows the yields available in the local currency markets of emerging market countries - some of which are a fair bit juicier than their US dollar-denominated equivalents.

The shift to local markets is being given a significant boost by some emerging market countries buying back their hard currency debt and therefore reducing the amount of available bonds. Increasingly they are looking to issue in their own currencies, thereby increasing the depth of their own markets and providing a new area for investors. This has been played out against a backdrop of improving balance of payments and fiscal discipline.

Monetary policies designed to synchronise interest rates down to traditional market levels are also helping. For central European countries it has been their desire to join the euro while Latin American countries have reaped the rewards of tight monetary policy that has reduced inflation and allowed local rates to converge towards US dollar levels.

In Asia meanwhile, the change in policy following the 1998 Asian crisis has led to a pronounced increase in reserves and a collapse in short-term rates as a result.

Despite this relatively recent move towards local investing, the best place to have put your money over the last 10 years was in the US dollar-denominated area. Using the EMBI Index (US$ denominated) an investor would have made a return of close to 275% whereas an ELMI (local currency) investor would have only received 144%. This is changing as US dollar yields fall and EM currencies rally.

There remain significant opportunities in local markets but they involve taking currency risk. The political environment in each country particularly affects currencies. A new government could remove the semi-independent powers of the central bank or throw out the plan to converge with the euro, for example. The year ahead is looking like a political minefield and includes:

Inevitably, these usually cause a brief period of volatility before the wall of liquidity reasserts itself, currencies stabilise and interest rates fall once more. If economic growth starts to turn, leading to social unrest, then a more radical change in policies may occur. For the time being the rewards of lower interest rates prompting strong stable growth are enough to keep the new governments from deviating from the chosen path. It would probably take an external shock, such as a recession in the US, before EM governments feel the need to change what has worked. So despite pre-election hype, a move away from convergence is unlikely just yet.

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