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A Bumpy But Rewarding Ride At PIMCO


Few portfolio managers are as influential in their area of expertise as Mohamed A. El-Erian, who oversees a portfolio of $20 billion in emerging-market debt for Pacific Investment Management Co. (AZ), based in Newport Beach, Calif. The PIMCO managing director has been known to prod developing economies to boost the rate of interest they pay on new bonds or dial back the offering size to appease him. International Finance Editor Chester Dawson recently discussed the market outlook with El-Erian:

How much potential is there for continued gains in emerging-market debt in 2005?

For investors, there's the advantage of both high initial yields and some upside for further price appreciation, but the journey is going to be bumpy. The reason is that outside influences will create volatility [exacerbated by] fast money, hedge-fund money. You saw that in January [when the U.S. Fed moved to hike rates]. This asset class is very sensitive to what we call "tourist dollars" that come in and go out. That's why external influences play such an important role.

Will the risk premium for emerging- market bonds narrow or widen this year?

We're looking for another 25 basis-point spread compression. Right now the [JPMorgan] Emerging Markets Bond Index is at 345, which means investors are getting paid 345 extra basis points over U.S. Treasuries. That will go down to 320 by the end of the year. In January it went up all the way to 371 and then came back down to 350.

We think Brazil and Russia will see larger reductions [in basis-point spread] than is implied by the average. Other countries where you're likely to see more narrowing include Ecuador, Mexico, Peru, and Ukraine.

Is there a danger of worldwide collapse in emerging-market bond prices?

There are certain countries whose risk is not fully realized by the market. The reason is that [their bonds] are part of [indexed] baskets, so you've had an indiscriminate buying of all emerging-market debt. Most hedge funds don't have the [research] infrastructure to tell them the difference between a Brazil and a Venezuela. They tend to view the asset class as a whole. But we don't believe these [high-risk countries] will have a systemic influence. We don't see them contaminating other credit. The big economies that really matter in terms of systemic influence -- Brazil, Mexico, and Russia -- are all on a strongly improving trend. There has been a tremendous migration upward in emerging-market credit ratings. That's attributable to much better fiscal and monetary policies.

Won't demand for emerging-market debt dry up with the Fed raising rates?

If the Fed continues to raise rates because the U.S. economy is gaining traction, the answer is no, because the counterpart of that is high [U.S.] demand, and that's good for emerging markets. But if the Fed is increasing rates to protect the dollar -- because the dollar has become vulnerable to the large current-account deficit -- then that's problematic for emerging markets. That would cause a significant decline in global growth. But we think there's a very low probability of that.

What are the chief risks ahead?

There are two. One [is] the ability of the U.S. to fund growing twin deficits. The U.S. has been able to fund them because of the kindness of Asian central banks. But there will have to be an adjustment. The second risk is one of policy complacency. The major issue facing developing nations today is too much capital inflow. They are constantly having to intervene and soak up dollars from the markets. There's always a risk that this leads to a relaxation of [fiscal and monetary] policy.

What about the impact of China?

[Emerging markets] view China mostly as a consumer as opposed to a producer. China is a market for their raw materials, not a competitor.

Why is local currency debt issuance up?

There's a lot of talk about the concept of "original sin." It refers to the fact that many emerging markets have sinned by getting themselves indebted in dollars rather than their local currency. That means when things go wrong and the currency depreciates, the [dollar] value of the debt goes up. What countries are trying to do is issue in the local market and issue less in the external debt market.

What does that mean for investors?

The local currency market is something you want to [approach] very carefully. You assume all the exchange-rate risk. And the exchange rate is the shock absorber in these economies.


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