from Follow the Money

Have emerging markets changed more than the markets?

May 27, 2006

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Emerging Markets

Is the lesson of the most recent bout of turmoil in the emerging world “emerging market economies have changed, but the markets have not”?

How have emerging economies changed since 1997, the last time money flowed their way in a big way?   Fundamentally, by saving rather than spending the commodity windfall, and by saving rather than spending the huge wave of capital that flooded emerging economies the past few years?   Obviously, there are exceptions – Eastern Europe, Turkey, India (now) and with oil prices high, Thailand and Korea -- all run current account deficits.   But in aggregate, the emerging world has a big current account surplus despite attracting (til the last two weeks) big capital inflows.

Some countries in my view have taken prudence to such excess that their prudence has become a risk.  China won’t use long-term capital inflows from FDI, let alone short-term flows to finance a current account deficit.  As a result, its burgeoning reserves are contributing to a domestic credit bubble, barely restrained by administrative controls.  Too many oil exporters still budget for oil at $25 and, since they peg to the dollar, often have weaker real exchange rates now than in 1998, when oil was $15.  

But there also have been real changes in places that needed real change.   Brazil has eliminated two of its three major vulnerabilities.   Its external debt is way down, its exports are way up.   It has basically eliminated its domestic dollar-linked debt (good move).   Alas, the combination of high domestic rates, lots of short-term debt and a relatively large fiscal deficit has proven a bit more intractable.   Turkey addressed one major vulnerability – its fiscal deficit is basically gone.   Of course, it also has a big housing and consumption driven current account deficit.   That too is a real vulnerability.  But with something like 70% of the Istanbul stock market in foreign hands, big falls in the lira and Turkish stocks now hurt London and New York more than the Turkish banks … at least one hopes.   

Important changes, all.  The emerging world looks very different today than it did in say 1997, at the peak of the previous wave of capital inflows from New York, London and Tokyo.

What of the markets?   Have they changed since the last emerging market crisis? Gotten better at differentiating the good from the bad? 

In some sense, the answer to the question "Have the markets changed?" is obviously yes.   Just look at the growth in hedge fund assets under management (and hedge fund fees – see Edward Chancellor of breaking views) and credit derivatives.  

In other ways, though, the answer seems to be no.

Flows into emerging economies recently have seemed rather indiscriminate.   And flows out certainly have been somewhat indiscriminate.    Stock markets fell in oil importers and oil exporters, in countries with current account deficit and current account surpluses.   That suggests the core cause of the correction is to be found in the markets of the center, not the policies of the periphery.    Turkey’s big and growing current account deficit didn’t stand in the way of record inflows in 2005 and the first quarter of 2006.

My post earlier this week had a rather provocative title, but as Jenny Anderson noted in Friday’s New York Times, adding a bit of exposure to fast rising stock markets in the emerging world was an easy way to boost returns over the past year and a half.  And those returns were far higher if a hedge fund had unhedged emerging market exposure.  Going long some Turkish stocks and short others did not generate the same returns as an outright long position.   There is nothing wrong with pure directional bets – relative value plays have risks of their own (see LTCM).  But it is also hard to perform well in good and bad times with a simple long position …  

Getting in early and getting out early took some skill, chasing 2005 returns didn’t.   And earlier this year, it sure seemed like lots of folks – levered and not levered – chased past performance.

Lex argues that the moves over the past two weeks reflect a general repricing of risk.  Steve Johnson of the FT made a similar point.  Rising volatility mechanically forces funds to cut back on risky positions to limit their value at risk –

“The selling was indiscriminate in emerging markets … “ said Jonathan Garner, analyst at Credit Suisse.    The selling was largely driven by a sharp rise in volatility,with the Vix index, often referred to as Wall Street’s “fear guage” hitting a two-year high.  This increased the “value at risk” of leveraged investors such as hedge funds, forcing them to cut long positions.   Many of the assets that had made the strongest gains this year, such as emerging markets, fell most sharply as a result.”

That story sounds a lot like 1998.

Last week, rising volatility meant less appetite for emerging market risk. 

But also risks of other kinds.   For example, holders of the most risky tranche of a synthetic collateralized debt obligation are demanding a lot higher premium to insure the holders of the other synthetic tranches against big losses  … 

The connection between emerging markets and the most risky (repackaged) corporate debt?  

Both appealed to common set of investors chasing returns in a low-volatility world …

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