THE credit crunch has accelerated the shift in global economic power to emerging market countries, led by the so called BRIC – Brazil, Russia, India & China – nations.
Evidence of this can be seen in the increased share of world GDP coming from EM countries as they continue to see growth, while the majority of the developed world is suffering from an anaemic recovery as the private sector slowly de-leverages.
In the developed world, the private sector has started to improve its balance sheet, whilst the public sector balance sheet has deteriorated as tax revenues have fallen and government spending has increased.
Historically, the credit ratings of EM countries have been dependent on the economic cycle.
The majority of EM countries were dependent on hard currency borrowings (mainly US dollars) which saw their abilities to service their debts largely reliant on foreign earnings.
Earlier recessions in the 1970s and 1980s were accompanied by falling commodity prices which, while providing a stimulus to the developed world, hit the earnings of many EM countries due to their dependency on commodity exports.
Since then, the majority of EM countries have significantly improved their economic positions with many (especially in East Asia) running large current account surpluses.
The key catalyst for the change in policy was the Asian financial crisis of the late 1990s when a number of countries suffered “hot money” outflows, which led to a serious contraction in output as countries were forced by the IMF to improve the structure of their economies.
Countries such as Korea, Indonesia and Malaysia realised that focusing on balanced public sector finances and running trade surpluses reduced the impact of external shocks (i.e. capital outflows) on their domestic economies.
While Asian countries have led the progress towards stable finances, a number of other emerging market regions have followed a similar path.
Latin American countries such as Brazil and Chile have benefited from higher commodity prices and have used their improved trade position to strengthen their economies.
The improved economic stability of many EM countries has improved the standing of their debt with investors.
The credit crunch and subsequent crisis in the eurozone, in contrast, has led to the downgrade of a significant number of developed countries’ debt.
The highest profile downgrade was the USA losing its AAA rating last year.
Both the US and Europe are currently facing fiscal strains with weak public balance sheets. While the US has not yet seen a significant fiscal consolidation, the mandatory cuts in government spending in 2013 may push the US back into recession.
The fundamental weakness of the eurozone, however, continues to be a drag on growth and the credit worthiness of the region. It has also led to the risk of a downgrade of the entire eurozone if a Greek exit from the euro leads to a significant negative macroeconomic shock.
A possibility of a disorderly Greek exit remains given the inability of eurozone’s politicians to implement a comprehensive solution to the crisis.
A final point to note is that, even before the credit crunch, the majority of developed world countries were likely to face increased age-related expenditure (healthcare and pensions) as the baby boomer generation retired and the dependency ratio increased.
Countries that previously had decades to solve the problem of ageing societies and the associated increases in government expenditure are forced to face the problem now due to the credit crunch increasing the public sector debt/GDP ratio.
Without clear policy action, the catch-up of EM countries with their developed counterparts is likely to continue, especially as the majority of EM countries are not currently facing a similar demographic shock.
For fixed income investors, the emergence of EM countries with better macroeconomic fundamentals than many developed countries may over the long run alter the concept of what constitutes a risk free asset.
Evidence of this can been by the strong inflows EM dedicated bond funds have received since the credit crunch.