TCS Daily

Risky Business

By Desmond Lachman - July 28, 2006 12:00 AM

On looking at the very forgiving way in which markets presently price emerging market risk, one is reminded of the story about Fischer Black, the famed MIT finance professor of Black-Scholes option pricing fame. When asked what he had learnt from working on Wall Street, he replied that he had learnt that the markets looked a lot better from Boston's Charles River than they did from New York's Hudson River.

For despite last month's sell-off in emerging market asset prices, these markets are still pricing the emerging markets as if they were virtually free of the risks that have traditionally characterized them. Indeed, countries with troubled financial histories like Argentina, Brazil, Russia, and Turkey now have to pay on average only 2 percentage points more than the US Treasury on their government borrowing from the market. This is a far cry from the 9 percentage points more than the US Treasury that they had to pay at the time of the Argentine financial crisis. And it's barely half the average spread that they have had to pay over the past decade.

While optimists might tout improved emerging market fundamentals as the primary reason for the spectacular boom in emerging market asset prices over the past three years, at best this is only part of the explanation. For by most measures, many emerging markets still have relatively high public debt levels, external financing dependency, and weak institutional arrangements that all make them vulnerable to any appreciable deterioration in the global environment. In addition, there are all too many emerging market economies, especially in Latin America and Eastern Europe, that are showing clear signs of reform fatigue and that are moving away from the orthodox policies of the past in the direction of more populist policies.

The more important part of the explanation for the dramatic boom in emerging market asset prices over the past two years is the extremely benign global environment that the emerging markets have enjoyed to date. Since the bursting of the US equity price bubble in 2001, interest rates in the United States, Europe, and Japan have been at highly accommodative levels. These low interest rates have given rise to asset price bubbles in many markets and they have been highly supportive of the emerging markets. At the same time, global economic growth has been at its highest level in twenty years, international commodity prices have reached record levels, and China has become a major buyer of emerging market goods.

A disturbing aspect of the presently elevated level of emerging market asset prices is that it does not seem to take into account the broad constellation of risks that presently threaten the continuation of the goldilocks world in which the emerging markets have been operating. These risks include an unprecedented large global payment-imbalance, the deflating of housing market bubbles in the Anglo Saxon economies, and a world oil market that is characterized by the lowest level of spare productive capacity in the past forty years.

As if those risks were not sufficient to shake emerging market investors out of their complacency there is also the ever-present risk of global terrorism, the risk of an avian flu outbreak, and the danger of an escalation of protectionist policies in response to China's ballooning trade surplus. As Shakespeare might have observed, it would seem that, like troubles, emerging market risks come not in single spies but in battalions.

What makes the market's complacency in the face of the very real risks that characterize today's world is the severe adverse consequences to the global economy should any of these risks materialize. This would certainly be true of any disorderly unwinding of the global payment imbalance given the very size of that imbalance as exemplified by a United States current account deficit of the order of 7.5 percent of GDP.

It might similarly be argued that any further increase in international oil prices would now have a much more severe impact on the global economic recovery than it has had to date. Up until now the negative impact of oil prices on global growth had been masked by a highly accommodative monetary policy stance in the G-3 countries. However, with interest rates in these countries now at more normal levels, one can no longer count on low interest rates to cushion the blow of high oil prices.

Niall Ferguson, the renowned economic historian reminds us that as late as July 1914 financial markets barely priced in the risk of the outbreak of the First World War. Looking at the way investors are pricing emerging market risk today, in the face of a plethora of identifiable and severe risks, one has to wonder whether financial market history might not be repeating itself.

Desmond Lachman is a Resident Fellow with the American Enterprise Institute.

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