Asian-Pacific Markets Essay -- Economy, Emerging Market

Asian-Pacific markets have been enjoying an extremely favorable economic climate generated by high global liquidity over the past three years. In 2006, for example, the excess of liquidity and the overall positive economic performance of these countries led to the lowest sovereign spreads in history falling below 200 basis points, as shown in Exhibit 1. Among the mechanisms contributing to this process are: 1) the low interest rates in mature markets (the U.S., the U.K., Europe, and Japan), until recently declining due to the burst of the dotcom bubble in 2000; 2) the steep yield curve, providing incentives for carrying leveraged positions; and 3) the low long- term interest rates in the U.S. relative to the country’s economic growth rate. The overall liquidity, together with the reduction on risk perception that it creates, have encouraged global institutional investors to take strategic positions in Asian-Pacific markets, thus narrowing the spreads even more. Furthermore, the average credit classification provided by international rating agencies for the countries composing the EMBI+ has gone up to the highest level ever (Ba1/BB+ as of September 2006), expanding the base of investors even more. This scenario has allowed Asian-Pacific economies to finance their debt via local currency issues in the domestic and foreign markets, thus allowing them to improve the composition of their public debt by extending its maturity profile, reducing the proportion denominated in foreign currency and accumulating reserves. Nevertheless, the crucial issue for Asian-Pacific markets is whether the current level of sovereign spreads is sustainable in the face a potential reversal of cyclical factors, such as those involving liquidity, ch... ... the dependent variable (interest rate), a common approach for determining sovereign spreads that significantly raises the coefficient of fit (R2 ). Third, the model uses macroeconomic fundamentals and gover- nance indicators specific to each country as explanatory variables, instead of proxies for repayment capacity. These proxies, generally ratings or other holistic constructs, are usually subject to criticism regarding the methodology for scale conversion or their ability to predict currency crises in Asian-Pacific economies.5 Furthermore, the proposed model analyzes the country-specific vulnerability (sensitivity) to a global risk shock. Such elasticities are further decomposed into eco- nomic fundamentals and governance indicators, with the objective of assessing whether, and to what extent, country vulnerability can be mitigated by improving such variables.