Guest post: The frontier tides they are a changin’

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By Gabriel Sterne, senior economist at Exotix Limited

Warren Buffett’s quote: “It’s only when the tide goes out that you learn who’s been swimming naked” became immortalised during the global financial crisis, and since then the emerging market tide has come back in and frontier markets have been riding the crest of the QE-supported wave. But the tide has started to turn again in Q3, posing the questions of ‘How far will it recede?’ and ‘Are there any naked bathers?’.

From mid-2010, investors regained their appetite for risk. With established emerging markets having taken off, investors piled in on frontier markets. The Exotix Frontier Average Sovereign Spread (EFASS) – which averages across 32 sovereigns – tightened 175 basis points (bp) in the nine months to April 2011. More mature emerging markets were left behind as the “frontier premium” (EFASS minus EMBI spreads) halved between August 2010 and April 2011.

And even within frontiers there has been convergence. Nowhere was the rally more pronounced than in commodity-rich Africa, whose average sovereign spreads against international benchmarks collapsed 240bps in the year to 4 July 2011.

European frontiers were also big ralliers over the last year. Easy global credit conditions and supportive foreign parent banks provided balance sheet amnesties that enabled even the most credit-boom and busted European frontiers to achieve fairly conventional cyclical recoveries, even in the face of significant fiscal retrenchment.

But for me Dubai – oil-less and locked in a disrupted region – stood out. In March there was a sudden surge of investor confidence in Dubai and what I refer to as its adopted 4Bs model (Burn Banks, Bailout Bondholders) to restructuring the debt of government-related enterprises. Value disappeared more quickly than it took to justify the words “Buy Recommendation”!

But with various brewing storms, a big question is whether frontiers weakened by the last global financial crisis have had enough time to put their swim-wear back on. Values look tight; the end of QE2 may signal an end of the global liquidity glut; even China appears to be slowing; and Greek fallout risk has escalated.

Most at risk could be European frontiers whose sovereigns so far largely got away with their private sector credit-fuelled booms and busts. Out of 92 banking systems covered in the IMF’s database, 20 have non performing loans (NPLs) over 10 per cent of total loans and 12 of these are in emerging Europe.

A key difference between two infamous boom and busters Latvia and Ireland is Sweden. Its banks kept Latvia afloat after the crisis, and Latvia’s 5-year eurobonds now yield 5.5 per cent, as opposed to Ireland’s 15 per cent. In a similar vein a key difference between Bulgaria and Ireland is…Greece (whose banks own 30 per cent of the Bulgarian banking system (along with Italy, Austria and Hungary whose banks own a further 40 per cent). Bulgaria is therefore in the front line should the problems of Greek banks escalate further.

How this European inter-connectedness plays out is key, and in my opinion Greek fallout risk is insufficiently priced into most European frontier markets, even after the historic agreement reached by EU leaders on 21 July, which will provide some respite in the emerging market space, but will not form a permanent tidal barrier.

Post Lehman’s, the financial world wildly under-estimated this interconnectedness. But yields on Bulgarian four year eurobonds of just 3.4 per cent, appear too tight given risks, and similar arguments can be made for other European frontier markets facing similar vulnerabilities.

The good news for frontier market investors however is that they are in a great position to exploit an under-rated aspect of frontier marketsits value as a diversification play.

The very rigidities which often hinder economic development may also shield a country from global financial interconnectedness in times of crisis. Albania and Bosnia were less attractive destinations for foreign banks to set up shop in the last decade, so had only modest credit booms in the late 2000s, and Egypt’s loyal state-owned banks stabilised the financial system during the revolution by acting as T-Bill buyers of last resort as the foreign buyers left in droves.

Furthermore, frontier risk is more often political and particular to the individual economies; frontier bonds are sometimes tightly held, and prone to illiquidity.

From a diversification perspective, a good frontier is one that is uncorrelated with overall shifts in average spreads. We calculated the top 12 least correlated with the EMBI and EFASS since January 2010. The list includes a number that have been subject to political concerns (Cote d’Ivoire, Pakistan, Egypt, Jordan, Bahrain, Belarus, Bosnia and Ecuador). Others are Montenegro, Albania, Vietnam and Dubai.

The usual disclaimer applies; past performance may be a poor guide to the future. Overall, however, the exercise confirms good diversification properties of frontier sovereigns. So it may still be a good time to jump on the frontier wave. But dress appropriately.

Related reading:
Ivory Coast: prospects amid strife, FT
Time to revisit those frontiers?, FT
In need of luck on the risky frontier

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