In the recently-concluded Bank-Fund Spring Meetings, the Bank moved forward with increased representation for developing countries. Notwithstanding civil society criticism that such a re-shuffle remains somewhat unsatisfactory, the changes nonetheless reflect the growing influence that such countries have on the direction of the global economy. As discussed in an earlier post, this new multipolarity can see seen in terms of the major contribution that emerging economies now exert on global growth.
The new multipolarity can be seen in many other areas beyond growth patterns. This week, contagion from the Greek debt crisis appears to have infected Portugal and Ireland, and there are increased concerns that Club Med economies and Ireland (EuroMed/Ireland) will face significant stress in the days ahead. Contrast this against the confident proclamations (PDF) following the recently-concluded (second) BRIC summit, especially concerning their role as engines of global economic recovery. Clearly, the BRICs, together with Mexico (the "BRICM"), are at a heady place, insofar as their economies are concerned.
Of course, governments are wont to exaggerate the relative performance of their economies. But markets are starting to take sit up and notice, too. Recent developments in bond markets suggest that, at a very nascent level, we are starting to see the increased recognition of the economic importance of emerging markets relative to mature ones. Consider, for example, yield speads on a GDP-weighted average of emerging market bonds with a 2-year maturity (from Brazil, Russia, China, and Mexico; data for India are not available), versus a GDP-weighted basket of bonds from Portugal, Ireland, Italy, Greece, and Spain (see figure). What is most remarkable is the trend decrease in spreads on the former, and the trend increase in spreads on the latter. In fact, average yields on these two sets of countries crossed recently, and it is difficult to see a reversal in these trends in the near future.
Notes: Yields on European government bonds obtained maturity approximating two years, and spreads calculated against the equivalent 2-year U.S. Treasury note. Stripped spreads on emerging markets obtained directly from J.P. Morgan. Countries were weighted by relative GDP within group, with 2009 GDP numbers.
Of course, it not an entirely fair comparison. After all, absolute GDP for the BRCM group is almost twice that of the EuroMed/Ireland group, while average nominal GDP per capita is about five times higher in the developed nations than the emerging ones. Still, any careful observer of the international financial system will undoubtedly be somewhat surprised that average yield spreads in this set of emerging markets is lower, rather than higher, than in the developed market set. To throw further fuel into the flame, public debt projections for the developed world offer no relief to the picture. To be sure, developed countries have always been able to sustain higher debt ratios, but with the notable exception of emerging Europe, developing countries by and large appear to be maintaining falling (or at least stable) debt burdens, which can only help whenever they choose to turn to global financial markets to raise capital.
We see a similar pattern in the CDS market, although here the markets appear to have priced in a higher likelihood of default among the EuroMed/ireland vis-a-vis the BRICM even before sovereign bond markets did so (see figure). Indeed, if trends in the CDS market are anything to go by, the differential between the two groups are likely to widen even further in the future.
Notes: Spreads obtained for CDS on 5-year sovereign debt. Countries were weighted by relative GDP within group, with 2009 GDP numbers.
A final hint that we may be moving into a brave new world (at least as far as sovereign fixed income is concerned) is the recent well-publicized phenomenon of a negative swap spread, termed a "mathematical impossibility" by the financial press. This, of course, cannot be true (by definition). It is useful to recall that the spread reflects the risks inherent in the (fixed leg of a) private-entity-issued swap, versus the corresponding fixed risk-free rate. Now, since there is no "true" risk-free rate, our imperfect world (and models) proxy this spread with short-term U.S. Treasuries. What the negative swap rate is hinting at, then, is that even the U.S. government, the force majeure of safe international finance, is starting to look a little shaky to creditors.
I am not the only one to notice the anomalous behavior of emerging versus mature markets in fixed income. Ramin Toloui writes about the consequences of fast-rising industrialized-country debt, calling it a "Region of Reverse Command", in reference to how standard Keynesian policy prescriptions may begin to lose traction in the developed world, rendering these economies more akin to emerging markets.
What does this brave new global financial landscape portend? The truth is, nobody really knows for certain. Perhaps we will see an end to the Lucas paradox, with capital finally finding its highest marginal product globally. Or perhaps there will be an end to original sin (PDF), and developing countries will finally be able to borrow in their home currencies. Or maybe Feldstein-Horioka correlations will finally fall, and there will be greater international risk sharing. The bottom line appears to be that we should keep our eyes open to the new possibilities that are emerging as emerging markets finally, well, emerge.