By the end of that month, the S&P 500 had declined 3.1 percent after thrashing about violently for two weeks. Riskier markets were savaged as startled investors sought to salvage some of their gains. The flight to quality, triggered by rising interest rates in the G3 (dollar, euro and yen) currencies, pummeled emerging-market assets in particular. Morgan Stanley’s emerging-markets index, which had been up almost 20 percent for the year at the beginning of May, saw those gains erased and fell another 6 points by May 17. Foreign investors’ losses were exacerbated by sliding currencies. The Brazilian real, for example, fell more than 10 percent against the dollar that month.

Despite the upheaval, emerging-market debt investors and strategists remain cautiously bullish. Many of these countries, they say, have strong GDP and employment growth, and inflation is largely under control. One positive indication of their longer-term prospects is the emergence and success of what is, essentially, a new asset class: debt denominated in their local currencies. This is less exposed (from the issuers’ point of view) to the vicissitudes of G3 currency markets and is a bellwether of growing investor confidence in key emerging markets.

"I am bullish on the asset class over the medium and long term," says Francis Beddington, London-based head of research for Central, Eastern Europe, the Middle East and Africa at Standard Bank. "We see faster growth in these countries compared with the core [developed countries], and we will continue to do so."

Countries that have pursued successful fiscal and monetary reform are the most promising. "We fundamentally believe the outlook for local debt is good, and that really is a function of rate-cutting cycles around the emerging-market universe, particularly in countries like Brazil and Mexico," says Edwin Gutierrez, London-based portfolio manager in emerging-market debt at Aberdeen Asset Management.

Tequila Hangovers
One of the concerns voiced in May was that the emerging markets, after three years of double-digit growth, could be teetering on the edge of another widespread debt crisis of the sort that erased billions in investor capital in the mid and late 1990s. But the pressures that precipitated those crises are largely absent today.

AHEAD OF THE HERD 5-year average annual GDP growth
Country	Percent, 2000-2004
China	8.52
Russia	6.84
India	5.74
Korea	5.40
Thailand	5.06
Hong Kong SAR	4.78
Indonesia	4.62
Turkey	4.34
Philippines	4.26
Singapore	4.12
Average World GDP Growth	3.84
Source: Pimco; International Monetary Fund, World Economic Outlook Database, April 2005.

To see why, a bit of history is in order. Many of the emerging-market economies pursued expansionary fiscal and monetary policies in the 1980s and endured falling reserves, high inflation and overvalued currencies. Reforms in the 1990s—including privatization programs, better banking oversight, anti-inflationary monetary polices, financial market and trade liberalization and more responsible fiscal behavior—stabilized many of the leading economies in Latin America and Asia. But many who sought to control prices by pegging their currencies to the dollar courted trouble. The pegs resulted in the currencies becoming overvalued, and they eventually collapsed under the weight of speculative attacks. Most emerging-market debt was denominated in dollars, yen or one of the European currencies (since few investors were willing to take two exposures: to the fortunes of the issuer itself and to the strength of its currency), and the devaluations of the local currencies made servicing the foreign currency debt prohibitively expensive. Defaults ensued—in Mexico in late 1994 (the knock-on effect this had on other Latin debt was known among traders as the "tequila effect"), throughout Asia in 1997 and in Russia in 1998.

The aftermath, though extremely painful for citizens of the countries themselves, as well as for their foreign investors, was cathartic. "When these countries went from a pegged exchange rate to a floating exchange rate, these were dramatic events, and some countries defaulted. But once that happens and the currency can now move and adjust, the country is much more flexible and is able to undertake reforms it might not have been able to do in the past," explains John Peta, Boston-based emerging markets portfolio manager with Standish Mellon Asset Management.

In particular, the governments were now freed from the need to spend their reserves trying to shore up their pegs. They could pursue more rational, independent monetary policies. "For the most part, they are putting those reserves in the bank and either paying down debt or not issuing as much debt," Peta says. "It is the debt-to-GDP ratios that the rating agencies look at, so the credit ratings have been improving on emerging-market countries." The change has been dramatic: Roughly 40 percent of the JPMorgan Emerging Bond Index is now rated investment grade, whereas a decade ago only 3 percent could make such a boast.