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Tuesday, November 27, 2007

Moving Money Into Emerging Asia

A number of news items related to capital flows have been catching my eye in recent days.

First off Claus Vistesen has a timely piece examining the possible implications of what seems to be an impending decision in Thailand to finally lift the capital controls imposed by the Bank of Thailand last December in an attempt to curb upward pressure on the Thai currency (the Baht). As Claus says "double digit percentage figures for potential Baht appreciation are already flying all over the place".

The looming Baht appreciation issue only serves to highlight a much broader tendency we are seeing at work in currency and capital markets in recent days, which could best be characterised as involving the search for "yield plus" - in this case yield plus the benefits of currency appreciation. This situation was highlighted with particular poignancy by an article in Bloomberg this morning which explained how the US Dollar itself may now be being used as a "carry currency":

"Using the dollar to pay for purchases of currencies with higher yields is proving to be the most profitable trade in the foreign-exchange market.....

Investors are borrowing dollars and using the money to buy assets in countries with higher interest rates even though U.S. borrowing costs are 4 percentage points more than the Bank of Japan's and 1.75 percentage points above the Swiss National Bank benchmark. In carry trades, speculators get funds in a country with low borrowing costs and invest in one with higher returns, earning the spread between the two."

The logic behind this is really quite a simple one, it is a bet that even though US interest rates are still higher than those in the normal carry currencies the most likely direction of movement for interest rates in the US is down, and as these rates go down so (the thinking goes) will the dollar. Really, as I explained in this post, this then creates a dynamic where it becomes very interesting to borrow in the country whose currency has the greatest potential for long term decline, and to buy (and preferably to buy property, but equities probably come a close second) in those countries whose currencies have the greatest potential for long term appreciation, and whose domestic assets the greatest potential for upward revaluation. We could call this the new found virtue of being poor and developing.

I also came across another Bloomberg piece drawing our attention to a Goldman Sachs report about how many hedge funds are now shifting their Asian investments out of Japan (because of lower returns and poor corporate governance) and into other areas of emerging Asia.

Japan's average return on equity will be about 10.2 percent this fiscal year, compared with 20 percent in the U.S. and 15.7 percent in Asia, according to Matsui. Return on equity is a measure of how well a company uses its cash to generate profit.

Meanwhile, Japanese companies are fending off purchases by foreign firms seeking to boost share prices, by buying stakes in each other or taking so-called poison pill measures. Some 400 Japanese companies, or 10 percent of all publicly traded firms, have taken steps to ward off hostile takeovers, according to a Nikkei newspaper survey published in October.

Hedge funds investing in Japan have seen outflows of about $7 billion, while Asia ex-Japan has seen inflows of about $17 billion through October this year, according to data provided by Eurekahedge, a Singapore-based hedge-fund research company.

On another front the New York Times reported on a growing trend in Japan among individual investors for reallocating funds they have invested in the U.S. to faster growing emerging markets. Japanese investors, it seems, have reduced holdings of domestic mutual funds investing in the U.S. in 16 of the past 17 months.

In fact investment inflows in overseas-oriented funds have consistently grown at a higher clip than the outflow from U.S. funds. An estimated half of Japan's $14 trillion in personal savings is believed to be invested overseas in search of higher returns, especially in terms of yield, given Japan's extraordinarily low returns on deposits and bonds. At the same time, Japanese investors are gradually beginning to diversify their holdings, after having only embraced mutual fund investing about a decade ago. According to data from Daiwa Fund Consulting, Japanese investors have invested the dollar equivalent of $17.5B into emerging market funds over the past year, while reducing holdings of North American funds by $4B. Fund management companies have taken notice, resulting in a 36% increase in the number of emerging market mutual funds to 183 in total (vs. 137 U.S.-focused funds).

Conclusion: hedge funds are reducing their involvement in Japan, and Japanese investors are reducing their exposure to the US, and they are both headed for emerging markets, and in particular emerging Asia and Latin American where a favourable combination of both assett price apppreciation, higher interest rates and currency appreciation appear to offer a much better longer term return. Morgan Stanley's Stephen Jen got near to the core of the issue last Friday when he pointed out that:

"If one had invested US$100 in 1985, the investment would be now worth US$739 for global real estate, US$639 for equities, US$403 for global bonds, US$264 for non-energy commodities and only US$182 for crude oil (including the recent surge in oil prices toward US$100 a barrel)."

So where in the world are equity and real estate values about to get (in dollar terms) the big ride up? I don't think the answer to this question is too taxing, even your average garden-variety hedge fund manager has the capacity to see this. The real question is how fast will it all happen, and has the dollar past an interim "point-of-no-return", or are we about to see a temporary dollar resurgence? Very hard to call this one, I think.

Afterthought: there does seem to be news to suit all tastes and appetites though, since Bloomberg also report that the rumourology has it that the Chinese government - via China Investment Corp. - is considering investing money in Japanese real estate. I would have thought the interests of their citizens would be better served by putting the money in Indian, Turkish or Brazilian real estate, but then, as they say, there are opinions around at the moment to cater for all tastes.

You can find a better explanation of the logic which I think is driving all of this in this post here.

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