TCS Daily


Defying Gravity in the Emerging Markets

By Desmond Lachman - October 13, 2006 12:00 AM

Emerging market financial assets, which have been among the best performing asset class over the past few years, continue to trade at lofty levels. They do so despite a stream of negative political news coming out of many emerging market countries that is all too reminiscent of the dark days of the mid-1990s. They also do so despite ever increasing signs of a US-led global economic slowdown and the consequent meltdown in prices of internationally traded commodities, which are still the very lifeblood of many emerging market economies.

The list of recent disturbing political news coming out of the emerging markets is impressive. Among the more eye-catching is a military coup in Thailand, the assassination of a deputy central bank governor in Russia, the fall of a government in Poland, the admission by a Hungarian Prime Minister that his government had consistently lied about the country's public finances, and the President of Ecuador publicly debating whether or not his country should default on its external debt.

To make matters worse, a whole series of recent elections in Latin America has revealed the public's growing impatience with the orthodox policies to which their governments had hewed, while in Eastern Europe many countries seem to be losing the will to comply with the requirements of joining the European Union. These developments pose the risk of undermining the great strides that many of the Latin American and East European countries have made over the past four years to strengthen their public finances and to reduce their external vulnerabilities.

The emerging market's deteriorating political outlook is coinciding with ever-increasing signs that we are coming to the end of the unusually strong global economic recovery that buoyed the emerging market economies over the past three years. The most immediate threat to the global recovery is the present unwinding in the US housing bubble. Over the past five years, unusually low interest rates have fueled an unprecedented 70 percent real increase in US housing prices. It has to be a disturbing portent for the global economy that US house prices are now actually declining on a year-over-year basis, while the inventories of unsold homes soars to record levels.

The prospective further bursting of the US housing bubble is hardly the only cloud presently hanging over the global economic recovery. Rather, that recovery could be adversely impacted by a disorderly unwinding of the historically large US payment imbalance that could lead to a rout of the US dollar. It could also be derailed by rising protectionist pressures against China, which doggedly insists on maintaining a grossly undervalued currency in an effort to keep its export machine humming.

The likelihood that the world economy might be headed for a significant slowdown is already reflected in a very strong rally in global bond markets. It is also reflected in a rather abrupt decline in commodity prices from the very high levels that they reached last May. Indeed, international oil prices have declined from a peak of US$78 a barrel in May to their present level of around US$60 a barrel, while over the same period, non-oil commodity prices, as measured by the CRB index, have declined by over 20 percent.

There would appear to be two possible explanations why emerging market financial assets are holding in so well despite the deteriorating political situation and despite the gathering storm clouds in the global economy. The more benign explanation is that emerging market economies are now in a very much stronger economic position than they have ever been before. This is thanks to their steady implementation of structural reforms and the pursuit of orthodox macro-economic policies over the last few years. With the notable exceptions of countries like Hungary and Turkey, most emerging markets presently have relatively strong public finances and small external borrowing needs.

The more troubling explanation of the relative strength in emerging market assets at a time of adverse political development is that financial markets in general are not pricing risk appropriately. In an environment of still ample global liquidity, markets continue to pursue yield and in that pursuit turn a blind eye to the risks underlying the assets that they are buying. This pursuit of yield is reflected in the tight levels of the high-yield market and the buoyancy of the equity markets. It is also strikingly reflected in relatively narrow credit spreads on troubled East European countries as well as in the appreciated levels of currencies like that of New Zealand, whose high interest rates deflect attention from the gaping deficit in its balance of payments.

Bitter experience would suggest that emerging market policymakers would be making a grave error in premising their economic policies on the assumption that the extremely benign external environment of the past few years will indefinitely persist. We already have abundant signs of the risk of a significant US economic slowdown while the unwinding of speculative commodity positions appears to be in full train. If those trends persist, one has to expect a very much greater degree of discrimination in the markets than at present between countries with sound and countries with shaky underlying political and economic fundamentals.

The author is Resident Fellow American Enterprise Institute and Economic Consultant.

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2 Comments

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That's got to be a bad metaphor if it's suggesting such a negative view. Surely the author is wrong to suggest that there's such a mistaken "not pricing risk appropriately". I think it's more true that other courntries are finally, at long last wiseing up to the fact that they can all get ahead if they just adopt proper policies re economic growth. So it's really humiliating when you see your neighbour get ahead, and often encourages you to open up your country too. It's the case in asia, and even latin america. Thus Venezuela even with it's massive oil revenues is a worse place for normal people, than Chile or Costa Rica without oil; muchless other countries with no oil, no gold, no nothing, like the asian tigers. Thus it's good that other areas are getting ahead meaning the world is less dependand on depressions from the States, especially when they see that liberals there are trying to go more socialistic, which everybody knows will lead to wrecking their economy. We should be happy former crappy countries are finally getting a clue.

Advanced Financial Capitalism had global traction and a strong bench...
Desmond,

Your proposition that financial assets in the emerging market arena may be overpriced is, of course, the eternal question all investors everywhere must pose. Is it time to buy or is it time to sell? Further, your argument poses two alternative solutions to the problem if such markets are indeed too high. Either the economies in question are in better shape than we might have expected or investors are accepting too much risk. Well, it could not be otherwise, could it? Either such prices are justified or they are not. Investors (and short sellers) will make money in either case.

However, an analysis of the underlying phenomena is the more interesting discussion. The Post Industrial Society and global financial economics are maturing. The integration of material, labor and overhead markets is going forward in spite of governments and their behavior. Cheap labor markets exist in countries with strong central governments (like China and India) and in places with weak democracies and entrenched corruption (like Malaysia and the Philippines).

A US led slowdown in the GDP growth rate has been a purposeful and orderly retreat from the unsustainable expansion pace of the past few years. China was especially overheated. This correction is healthy for the world economy and supports a continued bright outlook in some of the more vulnerable developing markets. It is a good thing.

All commodity prices (not just crude oil) were artificially over-inflated by traders and speculators. The fundamentals would not support this on the basis of supply and demand. So the smart producers accepted this extra money and kept their mouths shut. But no one with any sense expected this to continue. Any emerging market players who were foolish enough to depend on such extra margins were destined to fail anyway. This happens each and every time the market takes off and then corrects. And it simply clears away the hustlers. This is also a good thing for the world economy.

Absolutely nothing in the current (impressive) political news is any different in quantity or quality than ever. This is not a variable that changes the market. Negative political news is a constant.

Financial assets in emerging markets will enjoy a substantial response time lag if a decline in the US housing market actually puts us into a recession. The slowdown in US consumption that this housing slowdown implies coincides with a general, desirable, soft landing in the First Quarter 2007 anyway.

The Chinese yuan is not grossly undervalued any more than the US dollar is. When we dropped our interest rates, increased liquidity in support of the recovery and the dollar weakened against major currencies our products became more attractive in desirable foreign markets. The Chinese simply went with us. Their products also became (even) more attractive and their exports to the US were not hurt. The Chinese did precisely the right thing and we continued to exploit their cheap labor to increase our productivity and to enhance the profits of our own companies sourcing components and finished goods over there. It turned out to be great for us too! Our balance of payments with China looks terrible but their consumers are nowhere affluent enough for our products yet anyway. They are still buying television sets (made in China) and their very first automobiles (and those are not Cadillacs). Happily, they have lots of dollars to buy our T-Bills, Bonds and Notes. Healthy demand has kept these prices up and interest rates low. Lowering the carrying cost of our National Debt.

You posit that strong demand for bonds means that the slowdown is coming. If the market agreed with you then equities would be headed down now. Wrong. Equities are fine. Better than ever! Bonds are strong because people want them in their portfolios. Not because people are fleeing from stocks. Investors are also moving their money away from commodities as speculation has turned into short selling.

Finally, emerging markets in developing economies are maturing with the emergence of competitive, rapidly growing small companies in addition to the classic outsourcing operations of foreign investors come to extract raw materials and to exploit cheap labor. And leave behind nothing of enduring value when they move on.

Rule of law type reforms (laws of contract and property) and infrastructure investments are always helpful but local companies are already adept at dealing with the challenges and the subtleties within their own countries. This strong local bench of smaller players who are in the game now converting cheap labor into hard currency is the future of sustainable economic growth. Policy reforms do not result in GDP gains unless someone is standing by to do some business.

Vast opportunities with untapped upside for emerging markets are in financial services. Fast growing companies would not need outside capitalization if they could borrow working capital from their local banks. However, people cannot easily borrow money against the equity in their real estate because mortgage markets are primitive. Most start-ups cannot fund their working capital with credit card debt because such consumer credit is virtually non-existent. Commercial bank programs for asset-based small business loans and balance sheet loans for medium sized companies are not well developed.

These financial opportunites will be developed, emerging markets will become internally integrated and those developing economies will move crisply up the global food chain. This is already happening all over the world. But you don't need to look far. There are great investment opportunities right now in Mexico!

Interest rates are high in New Zealand and there is demand for the New Zealand Dollar for this reason. This is reflective of their robust growth rate and full employment. Their banks have lots of opportunites to turn deposits into loans. Their balance of payments deficits may not be a major concern as those NZ dollars come right back to the banks as deposit accounts adding liquidity. Yet New Zealand inflation rates are the lowest anywhere! Not a great example of an economy with substantial (ignored by the financial market) risk.




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