Standard Life Investments

Through the Lens

Russia, Ukraine and the curious lack of contagion - Emerging Market Debt

A notable trend in recent years has been the lack of contagion within the emerging market (EM) fixed income asset class. In the past, difficulties in one large EM country that resulted in pressure on its asset prices would quickly translate to asset price losses in other EM countries - regardless of whether there were any direct economic linkages. EM countries and asset prices often suffered from being guilty by association. This added to the perception that EM asset markets were inherently risky and volatile.

In recent years, however, this inter-EM contagion has been diminishing. The current crisis in Russia/Ukraine provides a perfect illustration of this point. These two nations combined represent in excess of 10% of the most widely used EM fixed income indexes. The situation unfolding in the former Soviet states not only has the potential to reshape the economic destinies of each country – it could potentially have global significance. And yet, despite the ongoing hostilities, EM fixed income assets have delivered very strong performance.

There are a number of reasons why EM asset markets are not suffering from contagion. For example, the establishment of widely used benchmarks has led to the asset class becoming increasingly institutionalised. And institutional investors tend to have a longer investment horizon, which in turn dampens volatility.

We believe, though, that it is the dominance of local investors within EM fixed income markets that is the most likely explanation for the lack of EM contagion.

Domestic investors own close to 70% of all the outstanding EM bonds. As national financial systems have developed, so too has the need for these investors to own fixed income assets. One example is the growth of EM pension fund assets. In the early 1990s, only a handful of EM countries had pension funds. Now almost every EM nation has a pension fund industry. The same is true of the EM insurance market. As a result, domestic investors have become the biggest drivers of asset price performance.

More than ever, it is important to recognise that each EM country is different. For example, the situation in Russia/Ukraine is not relevant for the structural reforms currently taking place in Mexico; nor does it affect whether the new Indian government will meet the current high expectations for transforming the country’s economy.

Having an in-depth understanding of the myriad of differences across all EMs and the relevant drivers of economic performance is therefore key to delivering alpha within an emerging market debt portfolio.