Where Are Emerging Markets Headed?

• Author: Mohamed A. El-Erian
• Position: Managing Director of the Pacific Investment Management Company (PIMCO), where he heads emerging markets portfolio management. He was formerly Managing Director at Salomon Smith Barney/ Citibank, and before that he was on the staff of the IMF for more than 14 years

Little more than a year ago, emerging markets were in turmoil. Investors, still reeling from the Asian and Russian crises, were watching a disorderly devaluation of Brazil's currency, the real, threaten financial stability throughout Latin America. The index of emerging market bond returns had declined by more than 17 percent in a 12-month period. Emerging economies were facing more difficult credit conditions: not only was the average spread standing at about 1,300 basis points (implying an average cost of 18 percent, before adjustment for the Russian restructuring), but the market for new issues was basically closed.

The emerging markets look very different in early 2000. Growth is picking up in most economies, with countries like Brazil also making remarkable financial recoveries and Mexico just being upgraded by Moody's to the much-coveted investment rating. The index of emerging market bonds is up 28 percent on a 12-month basis, surpassing all other pure fixed-income indices. Average spreads have narrowed to around 800 basis points. Thus, notwithstanding both higher interest rates in the industrial countries and the issuance by major emerging economies of more than $5 billion in new 10-30-year bonds in January alone, the average interest rate has declined to less than 15 percent.

This turnaround is particularly impressive given what else has been happening in international financial markets. For example, the U.S. treasury market has been volatile as it tries to adapt to new realities concerning treasury buybacks, as well as to the U.S. Federal Reserve System's tightening of monetary policy. Swap spreads are unusually wide, while the corporate market (high grade and high yield) is having to deal with its own dislocations as reflected in high and volatile credit spreads. And U.S. equities have exhibited their own type of volatility and dispersion. Meanwhile, on the emerging market front, four countries-Côte d'Ivoire, Ecuador, Pakistan, and Ukraine-have joined Russia in either defaulting outright on external debt obligations or implementing exchanges that, de jure, reduce the contractual value of creditors' claims.

Has the world changed so much that emerging markets can now be seen as an island of stability in a more turbulent international financial environment? Or are we watching a cyclical process unfold that promises another round of disruptions and crises for...