Singapore Exchange News

By Sam Goh

The aftermath of the global financial crisis has brought contrasting signals between developed nations and emerging economies. While emerging economies experienced much sharper contractions than the developed countries during the crisis, they also experienced much stronger rebounds. Despite the recent Euro zone debt crisis and the US structural problems, a number of developing countries are already back at their pre-2007 levels, while others are gradually recovering. In particular, the BRIC economies have displayed remarkable resilience during the global financial crisis. Between 2000 and 2010, the BRICs contributed almost 35% to global growth in US Dollar terms, compared with around 16% in the previous decade. In particular, since 2007, China alone has contributed more than any of them.

Since the start of the financial crisis, the BRICs’ contribution has risen even more: some 48% of global growth has come from the BRICs, up from 25% in the first six years of the decade2. The contribution from all emerging markets as a whole was over 80% (vs. the 2000-2006 average of 45%)3. While global growth from 2000 to 2007 was almost equally split between the developing and developed world, the last four years saw the trend change drastically, with the divergence mainly driven by the BRICs and the other emerging economies.

Increasing trade shares

The BRICs’ share of global trade has continued to rise sharply. In this case, China accounts for almost two thirds of the BRICs’ share. Korea and Mexico together account for more than half of the rest of emerging economies’ trade (Exclude BRIC), while other countries (such as Turkey, Indonesia and Vietnam) are becoming increasingly important too. The importance of this group in 2008 has increased even more, highlighting the resilience of the developing world to the crisis in general. This presents tremendous amount of investment opportunities for investors into these economies in terms of commercial trade and shipping etc.

Internal Consumption

Internal consumption is still the largest component to real GDP growth in most of the emerging economies. For instance, in China, both net exports and internal demand have made positive contributions to growth this decade. Contribution from domestic demand declined across the board in 2008 from the 2007 highs. However, this was still the main economic driver for all the emerging countries. On a broader perspective, domestic demand has also consistently driven growth in many economies. Some countries such as Indonesia, Mexico and Vietnam stand out in particular. When compared against the developed economies, it revealed a striking difference, particularly versus the BRICs. The contribution of domestic demand to growth in the North America and Euro land had slowed since the start of 2003 and registered negative figures in 2008 and 2011 during the global financial crisis and most recently, the Euro zone Debt crisis respectively.

Given the challenges (exports) that many emerging economies and markets have faced during the crisis, has their potential to grow and develop changed? In this article, we will look some of the critical components of the emerging economies so as to give an objective assessment on the investment opportunities available. The general assessment is that not only is the emerging economies’ growth story still intact—if anything, it has become even stronger.

BRIC’s Growth Story Continues to Remain Intact

Ten years after investment firm, Goldman Sachs, first coined out the BRICs’ growth story, all four countries have registered upside surprises. From 2003-2011, actual GDP growth turned out to be higher on average than projected, particularly in China and India. Even if we take into consideration the financial crisis, actual GDP growth is still significantly higher in China and India, and slightly higher in Brazil. Since 2008, China has been delivering a much higher average growth rate than many moderate economists had projected. Higher growth assumptions for Brazil and Russia have also been factor in for assessment over the next decade.

According to Goldman Sachs, China, the US and India could be the three largest economies by 20154. At the same time, Brazil and Russia could overtake Japan and Germany to become the fourth- and fifth-largest economies by 20505. In terms of income per capita, Russia will still probably be the richest economy out of the BRICs, with China, Brazil and India well behind it by 20506. Overall, the BRICs economies taken together could now be larger than the G7 developed nations by 2031, much earlier than anticipated.

Ever since the BRIC theme was identified, a number of fundamental shifts has been noted in relation to the rise of these countries could bring about in the global landscape. For example, the changes in consumption and production patterns resulting from the rise of the BRICs could be dramatic. Spectacular growth in demand for consumer durables goods such as cars and mobile phones in China is another good example to illustrate the above point. All these point to potential investment opportunities available for investors who are keen to take advantage of the emerging economies growth story. 1,000 people. This is over 100 cars per 1,000 people higher than we estimated before, and 30 times its current penetration level9! Hence, India is set to become the biggest auto market among the BRIC economies by 2030. At the same time, automobile projections for Brazil also reveal higher car penetration. This is projected to be around four times the current number. All in all, demand in auto mobile products and services in these emerging economies will present attractive investment opportunities for investors seeking portfolio diversification and capital appreciation.

Buoyant Energy Markets Spurred by Demand

In addition to global auto mobile demand, another investment opportunity that an investor should look at in the BRIC’s growth story pertains to the main and alternative energy markets. Just as with auto mobiles, China and India will be the two main players in the energy market. It looks likely to be influenced greatly by Chinese and Indian demand within the overall picture over the next 20 years. Over the past few years, the energy markets are often dominated by the policies adopted by the Chinese government. For instance, on November 26, 2009, Reuters cited a Xinhua report (quoting the State Council) that by 2020 China plans to have reduced its carbon intensity by between 40% and 45% compared with 2005 levels10. On a separate note, China has pledged to reduce energy consumption per unit of GDP by 70%-80% by 2050. To achieve this goal, 50% of new energy usage from now until 2030 will come from nuclear and renewable sources, and that all new power sources will be in these forms by 2050.

However, the picture becomes interesting when one applies to the use of non-renewable energies. Let’s take crude oil as an example. As discussed earlier, 50% of new energy needs by China will be met by renewable resources by 2030, and that all of them will be by 2050. If this is true, then up to 15mbpd of the possible projected 75.2mbpd globally might not take place. Thus, 20% of projected global oil demand from China may not occur. If India were to engage in something similar as China, then 35mbpd or 46% of the additional energy demand that was being projected earlier would not happen.

All these indicate that investors could turn to alternative energies for potential investment opportunities. According to Goldman Sachs’s analysts, while the Chinese policy indications appear to be good news, unless they can be implemented quickly and without something dramatic involving the US, the near to mid-term lack of energy supply suggests significant upside price risks remain, which could lead to weaker demand (through weaker growth).

Conclusion

The global financial crisis has been a major challenge for the world’s economies. At present, the ongoing Euro zone debt crisis as well as the US structural issues are two main determinants that may possibly put a dent to global economic growth. As discussed earlier in this article, the emerging economies collectively appear to have withstood and handled the crisis better than many of their developed-nation peers (G7). In fact, their overall contribution to the world’s economic activities has increased even more through the crisis. Therefore, it is likely that in the present context, the global economy may turn to emerging economies like BRICs for growth in the short, medium and long term. If this holds true, some of the emerging economies like China will become as big as the US by 2025. It is projected that the BRICs will collectively become as big as the G7 by 203012. Hence, among many aspects of the world economic scene and uncertainties, the emerging economies are expected to become increasingly important players in propelling global economic growth. With hindsight, many complexities and structural issues may arise in the future as a result of it. However, the general norm is that the emergence of these developing countries remains very attractive and offers substantial investment opportunities for investors.

Thailand’s SET had closed 2010 with a gain of nearly 41 percent. This was despite the domestic political tension, the ‘half-finished’ buildings doting its skyline from the days before the Asian Financial Crisis, and the recent credit crunch.

Exports of Thai goods and services and a good dose of stimulus measures have notched GDP growth up 7.1 percent. In fact, the World Bank is forecasting GDP growth for both 2011 and 2012 to be 3.7 percent and 4.2 percent respectively.

Domestic consumption, although having slipped marginally, still made up 51.4 percent of GDP and the higher export prices for agricultural produce has boosted Thailand’s exports-to-GDP ratio to 69 percent. Private investment, though, has failed to take up the baton when government spending receded. According to a report by S&P, growth in industrial output has slowed sharply to 6.5 percent in the second half of the year from 24.5 percent in the first.

SET Vs. MSCI Asia Ex-Japan

The orange line represents the Stock Exchange of Thailand while the green line represents the MSCI Asia ex-Japan. (Source: moneyweek.com)

On 3 July 2011, Yingluck Shinawatra, sister of former prime minister Thaksin, and her Pheu Thai Party won a landslide victory in Thailand’s parliamentary elections.

While political risks remain, “the election result is likely the best scenario to come of the political process,” said Allianz Global Investors in an email update to clients. It reasoned that “a resounding electorate win and an absolute legislative majority by Pheu Thai are likely to dispel any notion by the military or the establishment to react with any severe measures to contest the outcome of the election lest they catalyse further populist discord.” The outcome is likely to force the military and social establishment to find compromise with Pheu Thai over a number of outstanding issues, as Pheu Thai is now in a position to further entrench its political foothold through coalitions with other minority parties.

“The key to stability is military acceptance of the Pheu Thai win and the military has expressed that it accepts the election results and will not prevent Ms. Yingluck from forming a government, key signals of a peaceful transition,” it added.

Mike Kerley, a manager at Henderson Far East Income, shared his take on the election and his outlook for the Thai market. “Our view and that of the markets have been positive following the election. The market has been jittery prior to the election as it feared that (results with) no clear majority will lead to horse trading as the two main parties will fight for coalition partners to form a government. The majority won by Pheu Thai has removed this risk, however, coalition partners will still need to be found to gain a majority in the lower house, which will provide welcome checks and balances in the short term. The election win by a party connected to Thaksin Shinawatra could have caused anxiety, however, comments from the army stating that the people have chosen and backed the result is reassuring. Risks remain should the new government try to bring back the disgraced former leader but the stated pro-growth populist measures from the new government should encourage strong growth going forward… We remain positive on the short, medium and long-term outlook for the country.”

The Thai bourse, previously sluggish as traders kept to the sidelines, has risen 4.7 percent on a turnover of 63,110 million baht the day after the election. Foreign and local institutional investors have been net buyers, with transactions amounting to 10.7 billion baht and 4.5 billion baht respectively.

The iShares MSCI Thailand, an exchange traded fund, has also rallied some 5 percent on 5 July 2011 (4 July was a holiday in the US).

Singing a different tune, Credit Suisse, although positive on the economy, earnings and prospects for tax cuts, is taking a less optimistic view of the market in the light of an uncertain political outlook, unattractive valuations, and a less appealing inflation profile. “In addition to the higher election risk, inflation is accelerating at a time when it seems to be peaking in some other NJA (Non Japan Asia) markets, and valuations now appear less compelling than several months ago,” said the bank.

Looking Beyond The Headlines
The Thai economy is not without its merits. Public debt is about 40 percent of GDP. The new government should be pro-growth, and inflation is well under control – the Bank of Thailand has been among the first to rein in inflation with contractionary monetary policies.

On top of these, ASEAN’s GDP growth is projected at 5.4 percent. The region’s 500 million people and US$2 trillion GDP has a combined market capitalisation of US$1.8 trillion. Nicholas Cashmore, the Country Head (Indonesia) at CLSA Asia Pacific Markets, in a note to investors has commented that with its benign interest rates, strong public-sector balance sheets, an emerging middle class, and a spike in commodity prices, the best investment ideas are to be found in the region.

Performances of the larger investment companies based in Thailand seemed to confirm this. Aberdeen New Thai, the only pure Thailand-focused investment company, grew 102 percent over the last 5 years to 30 June 2011, whilst the average investment company is up 30 percent. Over the last year, Aberdeen New Thai has appreciated 25 percent, against the 19 percent rise in the average investment company.

Hugh Young, a manager at Aberdeen New Thai said, “Thailand is a perfect example of why investors should look beyond the headlines when making investment decisions. The merry-go-round of Thai politics could easily dissuade investors from looking any further into a fast growing economy which is home to some good quality companies. It has invested heavily in director training, adopted best practices with respect to accounting standards and other statutory processes, and boasts a generally strong and vibrant corporate sector. Furthermore, we have found that companies themselves tend to be in better shape than many of their counterparts elsewhere in Asia. Balance sheets are healthy, reflecting perhaps the extraordinary damage done during the Asian Crisis in the late 1990s and the extent to which lessons were learnt. As an investor, such fundamentals provide me with both comfort and excitement.”

In its release of the Thailand Economic Monitor – April 2011, the International Monetary Fund pointed out that “Thailand’s economic growth has broadened its base, with domestic consumption contributing more to growth than in the recent past and exports holding up well against the uncertain global outlook. Concerns about high prices of food and fuel are likely to persist in 2011, but the Thai economy is expected to weather these rough currents and post a solid performance during the year.”

Though not without risk, putting some money to work in Thailand is to participate in the growth of one of the more exciting countries in the world. The economy is strong and the country continues to be a favourite destination for direct foreign investments. What more can investors ask for?

Capital from hedge finds that are invested in Emerging Markets has reached a new record by the first quarter of 2011. Total assets being invested in Emerging Markets hedge funds have increased to over USD 121 billion, surpassing the previous record level of USD 117 billion set in 2007, according to data by HFR – a provider of hedge fund data. This increase of roughly 6.5 percent includes an inflow of USD 2.3 billion in new capital into Emerging Asia as well as a USD 5.1 billion in Russia and Multi-EM regions. Interestingly, capital focused on Latin America growth has posted the largest percentage increase, rising well over 15 percent.

“The record level of assets (being) invested in Emerging Market hedge funds represents the latest evidence that global investors continue to exhibit a preference for accessing specialized Emerging Markets exposure via hedge funds,” said Kenneth J. Heinz, President of HFR. “As a direct result of the strategic specialization, sophistication and improved structure of Emerging Market hedge funds, the number of funds located in Brazil, China, Russia, Singapore and UAE all continue to grow, and we expect this trend to continue in 2011 and in coming years.”

Capital is also pouring into ETFs and mutual funds that are focused on Emerging Markets. These collective investment schemes have gained USD 835 million in new money for the week ended 3 June, 2011. Asia is the largest recipient of this flow as traders pour USD 244 million into China, Taiwan, and Hong Kong (FXI, EWT, and EWH), while the reverse is true of South Korea, India, and Russia (EWY, INP, RSX) – the last due largely to oil, the mainstay of The Russian economy, not able to hold above USD 100. Brazilian funds (EWZ for instance), the darling of this writer, is up with a USD 132 million inflow.

In a separate report by Bloomberg, net private capital will keep pouring into emerging economies to reach USD 1.1 trillion by 2012, bringing with it, the threat of asset-price bubbles.

Yet all these are a fraction of global financial assets, which are estimated to have been as much as USD 250 trillion last year according to The Institute of International Finance, a global association of financial institutions based in Washington. The question is, in all these euphoria, are Emerging Markets still good investment ideas?

Very obviously, when too much money chases after too few goods, the Law of Demand and Supply ensures a higher equilibrium price. But logic aside, let’s take a look at how Emerging Markets stack up against the developed ones.

Stimuli to Emerging Markets equities and to developed ones are different, that is, they move for very different reasons. There have been talks, even theories, of decoupling between emerging markets and developed ones during the last financial crisis but they all prove to be wrong when equities worldwide have plunged in a synchronized fashion. In fact, emerging equities have fallen by more than developed equities. However, over a five-year period, some of the emerging markets are well ahead of developed ones.

Brazil, China, and India have performed better than the developed countries of Australia, Canada, and Germany (The USA is not included in this comparison as it is absurd to match data against a country whose GDP is that of entire Asia’s). The MSCI index five-year returns for these countries are as follows:

This optimism is not just limited to equity markets. Even ‘big-ticket items’ such as cross-border mergers and acquisitions reflect the above. According to KPMG’s latest Emerging Markets International Acquisition Tracker, the volume of Developed-to-Emerging (D2E) deals have increased by two percent to stand at 812. This could suggest that assets in the developed markets are no longer the attractive prospect they used to be.

Commenting on the findings, Ian Gomes, Chairman of KPMG’s High Growth Markets practice for KPMG in the U.K, says, “After the burst of activity early in 2010, there (has been) a general expectation that E2D deals (will) continue to increase. However, despite some cash-rich trade buyers and the presence of some hungry sovereign wealth funds, it hasn’t really happened. That’s not because potential targets are looking too expensive. Rather, I think that the developed markets themselves are – for the time being – no longer as attractive a proposition as they (have) previously (been) to these buyers.”

There are exceptions, though. “Buyers will still come to the West looking for brands, technology and intellectual property – to be put to use back in their own domestic markets. They’re not typically looking at the West as a market in its own right now, especially as Western consumer spending power continues to fade. This has major repercussions for Western businesses which need to reassess just how attractive they actually are to investors from those emerging markets,” says Gomes.

In the report, Global Development Horizons 2011 — Multi-polarity: The New Global Economy, The World Bank has projected that by 2025, six major emerging economies — Brazil, China, India, Indonesia, South Korea, and Russia — will account for more than half of all global growth, and the international monetary system will likely no longer be dominated by a single currency. As economic power shifts, these successful economies will help drive growth in lower income countries through cross-border commercial and financial transactions.

Emerging economies are projected to grow on average of 4.7 percent a year between 2011 and 2025. Advanced economies, meanwhile, are forecasted to grow by 2.3 percent over the same period, yet will remain prominent in the global economy, with the euro area, Japan, the United Kingdom, and the United States all playing a core role in fueling global growth.

“The fast rise of emerging economies has driven a shift whereby the centers of economic growth are distributed across developed and developing economies – it’s a truly multipolar world,” says Justin Yifu Lin, the World Bank’s chief economist and Senior Vice President for development economics. “Emerging market multinationals are becoming a force in reshaping global industry, with rapidly expanding South-South investment and FDI inflows. International financial institutions need to adapt fast to keep up.”

A Snapshot

Hedge funds end ten-month winning run; still outperform markets

Hedge funds have been down 1.15 percent in May, ending a ten month winning run for the industry according to Eurekahedge. However, managers in all regions have outperformed their respective underlying market indices, as the MSCI World Index has declined by 2.52 percent during the month.

Below are the highlights for May:

• Hedge funds in all regions outperformed underlying markets.
• Net asset flows remained positive – USD 4.7 billion of capital invested in hedge funds.
• Net asset flows for first five months exceed USD 100 billion.
• Latin American managers deliver positive returns for May, up 0.65 percent.

Relative value hedge funds up for twelfth consecutive month, gaining 12.30 percent during this time

Latin American hedge funds have delivered the best performance in May, making it the fourth consecutive month of positive returns. The Eurekahedge Latin American Hedge Fund Index has been up 0.65 percent during the month, bringing its YTD return to 3.41 percent. The MSCI EM Latin America Index, though, has been down 3.18 percent. Japan has outperformed underlying markets, losing 0.24 percent relative to the Nikkei 225 which has declined 1.58 percent. Japanese managers have been positioned conservatively at the start of the month and hence have been able to protect their capital in a market that has tracked global movements weakly.

It cannot be denied that Emerging Market growth over the last decade has been tremendous. In the future, as these countries gradually catch up with advanced economies, one can assume that their stock markets will continue to reward investors with strong returns over the long run. The road ahead, though, will be a bumpy one. Take the Emerging Market Index ETF (EEM) for instance. It has returned a hefty 22.6 percent annual return (CAGR) since inception in April 2003, but at the expense of extremely high volatility (36 percent). The Vanguard Emerging Markets ETF (VWO) records roughly the same figures.

For those better equipped to stomach such volatility, I’ll say put your money where the future is.

(This writer has positions in EWZ. Investors worldwide have withdrawn USD 222 million from Emerging Markets equity funds in the week ended June 8 since the writing of this article.)

“It was the spring of hope, it was the winter of despair,” begins Charles Dickens’ The Tale of Two Cities. In 2011, the winter of despair was followed by the spring of uncertainty. Due to the earthquake/tsunami in Japan, the continued tribulations of Greece, rising commodity prices, and growing concern over the global economic recovery, volatility in the forex markets has risen, and investors are unclear as to how to proceed. For now at least, they are responding by dumping emerging market currencies.

As you can see from the chart above (which shows a cross-section of emerging market forex), most currencies peaked in the beginning of May and have since sold-off significantly. If not for the rally that started off the year, all emerging market currencies would probably be down for the year-to-date, and in fact many of them are anyway. Still, the returns for even the top performers are much less spectacular than in 2009 and 2010. Similarly, the MSCI Emerging Markets Stock Index is down 3.5% in the YTD, and the JP Morgan Emerging Market Bond Index (EMBI+) has risen 4.5% (which is reflects declining growth forecasts as much as perceptions of increasing creditworthiness).

There are a couple of factors that are driving this ebbing of sentiment. First of all, risk appetite is waning. Over the last couple months, every flareup in the eurozone debt crisis coincided with a sell-off in emerging markets. According to the Wall Street Journal, “Central and eastern European currencies that are seen as being most vulnerable to financial turmoil in the euro zone have underperformed.” Economies further afield, such as Turkey and Russia, have also experienced weakness in their respective currencies. Some analysts believe that because emerging economies are generally more fiscally sound than their fundamental counterparts, that they are inherently less risky. Unfortunately, while this proposition makes theoretical sense, you can be assured that a default by a member of the eurozone will trigger a mass exodus into safe havens – NOT into emerging markets.

While emerging market Asia and South America is somewhat insulated from eurozone fiscal problems. On the other hand, they remain vulnerable to an economic slowdown in China and to rising inflation. Emerging market central banks have avoided making significant interest rate hikes (hence, rising bond prices) – for fear of inviting further capital inflow and stoking currency appreciation – and the result has been rising price inflation. You can see from the chart above that the darkest areas (symbolizing higher inflation) are all located in emerging economic regions. While high inflation is not inherently problematic, it is not difficult to conceive of a downward spiral into hyperinflation. Again, a sudden bout of monetary instability would send investors rushing to the exits.

While most analysts (myself included) remain bullish on emerging markets over the long-term, many are laying off in the short-term. “RBC emerging market strategist Nick Chamie says his team has recommended ‘defensive posturing’ to clients since May 5 and isn’t recommending new bullish emerging currency bets right now….HSBC said Thursday that it isn’t recommending outright short positions on emerging market currencies to clients but suggested a more ‘cautious’ and selective approach in making currency bets.” This phenomenon will be exacerbated by the fact that market activity typically slows down in the summer chart above courtesy of Forex Magnates) as traders go on vacation. With less liquidity and an inability to constantly monitor one’s portfolio, traders will be loathe to take on risky positions.

In my previous update on emerging market currencies, I wrote that in the short-term, it’s important not to lump them all together; high-yielding currencies must be distinguished from low-yielding ones. In this post, I’m going to backpedal a bit and argue that over the medium-term and long-term, emerging market currencies as an asset class are still a good bet.

Most emerging market central banks have already begun to tighten monetary policy in order to mitigate against runaway inflation, overheating economies, and asset bubbles. You can see from the chart above (where a dark shade of green signifies a higher benchmark interest rate) that the overwhelming majority of high-yielding currencies belong to emerging market economies. (In fact, if not for Australia, it would be possible to say all high-yielding currencies).

While industrialized central banks are also expected to begin tightening, the timetable is much less certain, due to slowing growth, high unemployment, and low inflation. If current trends continue, then, interest rate differentials should only widen further between industrialized currencies and emerging currencies. Without taking risk into account, the most profitable carry trade will involve shorting the lowest-yielding currency against the highest-yielding currency(s). Alas, liquidity must also be taken in account, and the Angolan Kwanza – with an interest rate of 20% – is probably not a viable candidate. As one fund manager summarized, “[If] we feel like it’s a country where if we exit we are sort of going to shoot ourselves in the foot [due to lack of liquidity], then we won’t go in the first place.

Over the long-term, meanwhile, emerging market currencies will receive a boost from two related forces: strong fundamentals and capital inflows. With regard to the former, emerging market economies already account for the lion’s share of global GDP growth. The World Bank projects that over the next 15 years, emerging market economies will collectively expand by 4.7%, compared to 2.3% in the developed world. As a result of this strong growth, combined with fiscal prudence, debt levels across the developing world are generally falling. It marks a significant reversal that none of the current sovereign debt crises involves an emerging market country. What is more amazing is that some emerging market economies (Mexico, Russia, and Brazil) that struggled with bankruptcy less than a decade ago now have investment-grade credit ratings!

As a result, capital flows into emerging markets should continue to surge. Even though emerging market equity and bond funds have witnessed record inflows over the last few years, portfolio allocations still remain extremely low. For example, “U.S. defined-contribution pension plans only have 2.1% of their funds allocated to developing economies, which make up nearly 50% of global GDP.” Emerging market bonds, meanwhile, account for an estimated 1% of total assets under management. This trend will be further reinforced by domestic investors, which will probably opt to keep more capital in-country.

Of course, the risks are manifold. First of all, there is a risk that these capital inflows will provoke a backlash. “Emerging countries have adopted a broad range of measures to regulate inflows and stem currency rises, increasingly resorting to capital controls and so-called macro-prudential measures such as credit curbs.” Now that they have the blessing of the IMF, emerging market currencies might conceivably be more audacious in trying to limit currency appreciation. On a related note, there is also the possibility that emerging market central banks will fall behind the curve, perhaps deliberately. Lower-than-expected interest rates and hyperinflation would certainly dent the attractiveness of going long such currencies.

Finally, it is possible that in all of their excitement, investors are bidding up emerging market assets to bubble levels. The Wall Street Journal recently reported, for instance, that commodity prices and emerging market currency returns have become strongly correlated. Given that many of these countries are in fact net importers of energy and raw materials, this shows that emerging market currencies are rising more in proportion to risk appetite than to economic fundamentals. If when this risk appetite ebbs, then, this could send emerging market currencies crashing.

A picture is truly worth a thousand words. [That probably means I should stop writing lengthy blog posts and instead stick to posting charts and other graphics, but that's a different story...] Take a look at the chart below, which shows a handful of emerging market (“EM”) currencies, all paired against the US dollar. At this time last year, you can see that all of the pairs were basically rising and falling in tandem. One year later, the disparity between the best and worst performers is already significant. In this post, I want to offer an explanation as to why this is the case, and what we can expect going forward.

In the immediate wake of the credit crisis, I think that investors were somewhat unwilling to make concentrated bets on specific market sectors and specific assets, as part of a new framework for managing risk. To the extent that they wanted exposure to emerging markets, then, they would achieve this through buying broad-based indexes and baskets of currencies. As a result of this indiscriminate investing, prices for emerging market stocks, bonds, currencies, and other assets all rose simultaneously, which rarely happens.

Around November of last year, that started to change. The currency wars were in full swing, inflation was rising, and there were doubts over whether EM central banks would have the stomach to tighten monetary policy, lest it increase the appreciation pressures on their respective currencies. EM stock and bond markets sputtered, and EM currencies dropped across the board. Shortly thereafter, I posted Emerging Market Currencies Still Have Room to Rise, and currencies resumed their upward march. It wasn’t until recently, however, that bond and stock prices followed suit.

What changed? In a nutshell, emerging market central banks have gotten serious about tackling inflation. That’s not to say that they raised interest rates and accepted currency appreciation as an inevitable byproduct. On the contrary, they have adopted so-called macroprudential measures (quickly becoming one of the buzzwords of 2011!), with the goal of heading off inflation without influencing broader economic growth. Most EM central banks have sought to achieve this by raising their required reserve ratios (see chart above), limiting the amount of money that banks can lend out. In this way, they sought to curtail access to credit and limit growth in the money supply without inviting a flood of yield-seeking investors from abroad. Other central banks have gone ahead and hiked interest rates (namely Brazil), but have used taxes and other types of capital controls to discourage speculators.

You can see from the chart of the JP Morgan Emerging Market Bond Index (EMBI+) below that EM bond markets have rallied, which is the opposite of what you would normally expect from a tightening of monetary policy. However, since EM central banks have thus far implemented tightening without directly influencing interest rates, bond yields haven’t risen as you might expect. In addition, whereas sovereign credit ratings are falling in the G7 as a result of weak fiscal and economic outlooks, ratings are actually being raised for the developing world. As a result, EM yields are falling, and the EMBI+ spread to US Treasury securities is currently under 3 percentage points.

The primary impetus for buying emerging markets continues to come from interest rate differentials. Given that interest rates remain low (on both an historical and inflation-adjusted basis), however, it’s unclear whether support for EM currencies will remain in place, or is even justified. Furthermore, I wonder if demand isn’t being driven more by dollar weakness than by EM strength. If you re-cast the chart above relative to the euro, the performance of EM currencies is much less impressive, and in some cases, negative. This trend is likely to continue, as Ben Bernanke’s recent press conference confirmed that the Fed isn’t really close to hiking interest rates.

Ultimately, the outlook for EM currencies is tied closely to the outlook for inflation. If raising the required reserve ratios is enough to head off inflation (and other forces, such as rising commodity prices, abate), then EM central banks can probably avoid raising interest rates. In that case, you can probably expect a correction in forex markets, which will be amplified by rate hikes in the G7. On the other hand, if inflation continues to rise, broad EM interest rate hikes will become necessary, and the floodgates will have been opened to carry traders.Either way, the gap between the high-yielding currencies and the low-yielding ones will continue to widen. In answering the question that I posed above, I expect that regardless of what happens, investors will only become more discriminate. EM central banks are diverging in their conduct of monetary policy, and it no longer makes sense to treat all EM currencies as one homogeneous unit.

Despite strong buy calls from research houses, this counter’s share price suffered from a prolonged period of weakness. However, recently, a strong uptrend seemed to be emerging for this counter. Refer to the orange color trendline support. Is this…



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Asian Stocks, Emerging Currencies Drop on Japan Quakes, Oil; Euro Weakens
Asian stocks snapped a three-day gain and emerging-market currencies fell after a series of earthquakes struck near Japan’s damaged Fukushima nuclear plant and oil traded above $105 a barrel. The euro weakened.

I ended my previous post on the subject by noting that emerging market Central Banks were at a crossroads. Either they would raise interest rates and accept currency appreciation, or they would risk hyperinflation and economic instability. While the jury is still out on a handful of cases, it looks like most of the emerging market countries in Asia have chosen the former.

In February, the Bank of Indonesia raised its benchmark interest rate to 6.75%, from a record low of 6.5%. The People’s Bank of China (PBOC) has now hiked rates three times in the current tightening cycle. After a hike in January, the Bank of Korea inscrutably decided to hold rates in February, but signaled that another rate hike in March is likely. The Central Bank of The Philippines similarly indicated that it is ready to embark on a program of tightening. The same goes for the Reserve Bank of India (RBI). So far the main holdout is the Bank of Thailand, whose interest rates are still the lowest in Asia (ex-Japan) and remains reluctant to raise them too quickly.

Towards the end of January and the beginning of February, most Asian EM currencies sputtered in their appreciation. While there were a number of reasons for this (notably a pickup in risk aversion), Central Banks rejoiced in their perceived victory of foreign currency speculators. Unfortunately, there were a few downsides to this. First of all, capital outflow produced marked declines in Asian stock and bond markets, raising borrowing rates for everyone making it more difficult for domestic firms to raise capital. Meanwhile, inflation continued to rise, with no signs of slowing.

Thus, as I remarked the last time around, it was inevitable that (Asian) Central Banks would inevitably come to their senses. First of all, they realized that there was no free lunch, and that controlling their currencies would disable them from using traditional monetary policy tools to fight inflation. Second, while they could do without currency appreciation, they realized that this would have to be tolerated if they wanted to continue attracting foreign investment. (That’s because, as the Financial Times pointed out, currency appreciation probably accounts for half of all emerging market investment returns).

Third, it is inevitable that emerging market currencies will continue to rise over the long-term, in line with productivity gains. According to the Balassa-Samuelson effect, “countries with above average real income growth should have rising price levels, relative to other economies, and strengthening real exchange rates.” Based on this notion, emerging market currencies are forecast to rise by an average of 1.7% per year for the next 10 years.

Finally, in accordance with the unofficial rules of the currency war, emerging market countries are competing not with industrialized countries, but with each other. If all of their currencies rise in unison, export competitiveness is unaffected, inflation is tamed, and foreign capital remains abundant. It would seem to be a win/win/win.

In fact, it seems like investors are less interested in distinguishing between the different emerging market currencies of Asia, since at this point, all of them offer similar currency appreciation (over the last six months, returns have converged) and similar inflation-adjusted carry. Thus, it stands to reason that as Asian Central Banks continue to tighten interest rates, their currencies will continue to rise together.

By now, we’re all too familiar with both the so-called currency wars and its underlying cause – the inexorable appreciation of emerging market currencies. As more and more Central Banks enter the war in the form of forex intervention and capital controls, however, they are inadvertently stoking the fires of price inflation. They will all soon face a serious choice: either raise interest rates and cease trying to weaken their currencies or risk hyperinflation and concomitant economic instability.

This dilemma is fairly basic: a Central Bank cannot simultaneously control its currency and conduct an independent monetary policy. For example, if it seeks to adjust interest rates to serve domestic economic goals, it must understand that this will have unavoidable implications for demand for its currency, and vice versa. These days, that dilemma is becoming increasingly sharp. Inflation in many emerging markets is rising to dangerous levels, real interest rates or negative, and all the while, latent pressure continues to bubble under their currencies.

The problem is that investors have become so desperate for yield that they are willing to tolerate negative real interest rates in the short-term if they believe that interest rates and/or currencies will inevitably rise over the long-term. While capital controls have forced a modest decline in the carry trade, the expectation is that an inevitable tightening of monetary policy will soon make it viable once again.

Due to the ongoing (perception of) currency wars, emerging market Central Banks are trying to hold out for as long as possible, lest they make themselves into sudden targets for carry traders and currency speculators. Some have already bitten the bullet. Brazil, for example, raised its benchmark Selic rate to 11.25% recently and indicated additional rate hikes will follow. China has embarked on a similar path, but from a lower base. The majority of countries remain in firm denial, however. Last week, Turkey took the unbelievable step of lowering interest rates in a vain attempt to decrease pressure on the Lira.

Most Central Banks believe that they can enjoy the best of both worlds by cutting access to credit and raising banks’ reserve requirements (in order to combat inflation) and maintaining strict capital controls (in order to limit inflation). While they should be patted on the back for creativity, such Central Banks must understand that their efforts are probably doomed to fail over the long-term. That’s because currency investors understand that only a masochistic, short-sighted Central Bank would pursue a weak currency policy in spite of rising inflation for a sustained period of time. Unless economic growth slows (which is unlikely without certain policy measures) and/or inflation magically abates (due to steadying food/commodity prices, etc.), they will eventually have no choice to concede defeat. “Central banks view the level of exchange rates as the priority rather than using them to help slow inflation. Once you start targeting multiple objectives, the odds for policy mistakes increase,” summarized one strategist.

The only win/win solution involves a simultaneous appreciation of all emerging market currencies. This would alleviate some inflationary pressures without altering the competitive dynamics of national export sectors and negatively impacting economic growth. According to the Financial Times, “There could be a surprise agreement to rebalance currencies at the Group of 20 this spring, although the failure of its November summit does not augur well.” Besides, any agreement would probably be in the form of a reiteration of the status quo, in which emerging markets independently (rather than in concert) pursue similar economic policy objectives.

For better or worse, emerging market governments have started to refocus the blame for the currency wars away from the US and towards China. Regardless of whether the US is at fault for its quantitative easing program, emerging markets compete with China – and its allegedly undervalued currency – in matters of trade. Pressuring China to allow the Yuan to appreciate, then, would ultimately go a lot further in ending the currency war and eliminating their predicament than screaming at the Fed for flooding the world with Dollars. Due to a new President and shifting politics, Brazil is angling to force the issue.  Given that China is currently in the same boat (rising inflation with low interest rates), this might be the straw that breaks the camel’s back. “China may be more sensitive to what the other major emerging market countries think about its currency. It undermines their moral high ground when it’s Brazil criticizing them instead of the U.S,” observed one analyst.

In any event, barring some unforeseen crisis and a flare-up in risk aversion, emerging markets are expected to continue attracting outside capital (more than $1 Trillion in 2011 alone), and their currencies are expected to continue their steady, upward march.