from Follow the Money

If Zambia can create assets that appeal to US investors …

May 18, 2006

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It seems like some investors in the US are dabbling in Zambian t-bills.   Or at least were until a few days ago.  

The flow of private money from the US to many emerging economies is one reason why I have some trouble with (quite popular) theories that argue that emerging economies cannot create financial assets that their own citizens want to hold, and therefore, must finance the US.   These theories seem premised on the belief that US is good at creating financial assets that investors in fast growing parts of the world want to hold, while fast growing emerging economies cannot create financial assets that their own citizens, let alone foreign investors, want to hold.  

To quote Daniel Gross:

Yes, people in China—and in India, or Brazil, or the Persian Gulf—are saving tons of money, in large part because they're selling goods and services to wealthy Americans and Europeans. But they don't trust their own poorly developed capital markets, banks, or corporations to take good care of their yuan, reais, and rials ... But the U.S. stock and corporate-bond markets offer investors around the world the ability to gain exposure to the global economy.

What's wrong with that picture? 

Well, right now, China's banks aren't having any trouble creating renminbi denominated financial assets that Chinese citizens want to hold.   China is tightening controls on inflows -- not on outflows.   Its government is practically begging Chinese citizens to invest more abroad.   Among other things, China has been holding its domestic rates below US rates to try to discourage inflows, and maybe even encourage outflows ...

China is an extreme case, but more generally, private capital is flowing into emerging economies, not out of emerging economies.   Private capital outflows from Russia have dried up, while private inflows into Russia have picked up.   Some foreign investors kind of like Gazprom's profit margins, if not its management structure.  That is one reason why Russian reserve growth has been so strong.  And the same holds for most of the emerging world.  Last year, Turkish citizens' desire to move funds abroad paled relative to foreign investors desire to move funds into Turkey. That's why Turkey's reserves went up in the face of a large current account deficit.  And so on.

Indeed, the available evidence suggets that -- at least until a few days ago -- US financial markets were having far more trouble creating the financial assets that Americans wanted to hold than many emerging economies were having creating financial assets their citizens wanted to hold.   At the New York Times story emphasized, lots of Americans have been rather underwhelmed by the performance of US equity markets relative to foreign equity markets ... and perhaps a few even prefer financing countries with current account surpluses to holding the currency of a big deficit country.

I think there was perhaps a bit too much interest in rather exotic investments in some parts of the US.  Last year's vogue for emerging markets may not last.  Things are a bit more volatile now -- everything is not just going up.  And investors who previously dumped money in all emerging economies have started to at least reduce the pace of inflows -- and thus of reserve growth.  Some even think that is one reason why the dollar has bounced back a bit.   The FT:

Steve Pearson, chief currency strategist at HBOS, suggested an alternative theory for dollar strength. Mr Pearson pointed out that foreign investors pulled $1bn from the equity markets of Thailand, India, South Korea and Taiwan on Thursday as a global flight to safety continued.

He argued that ongoing outflows from Asian emerging markets will slow the growth of reserve accumulation in these countries, reducing the need for Asian central banks to sell dollars and buy euros in order to maintain diversified reserves.

...  “As this support drops away, data on emerging market central bank FX reserves suggest last week was huge for reserve accumulation but this week has seen almost zero, the euro rally will become more and more vulnerable to a reversal.” 

I still find the notion that the currency of a country with a 7% of GDP current account deficit is a "safe haven" a bit puzzling.  But the recent reduction in the industrial world's willingness to take emerging market risk doesn't change the big picture: in the past few years, emerging market reserves have grown precisely because local investors have wanted to keep their savings at home, and on top of that, foreign money has flowed into the market.   

And even now,  private  flows from emerging economies are NOT financing the US deficit -- at least not unless you consider the Kuwait's Investment Authority a private investor.

The argument that emerging economies cannot create assets that their citizens -- let alone foreign investors -- want to hold had some truth during the dark years from 1997 to 2002 or even 2003.  But it doesn't describe the world in 2004 or 2005.  Risk spreads collapsed.   US investors swooned over emerging economies.  And the private citizens of a lot more emerging economies started keeping their savings at home too.

More on this later -- much more.

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