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Thursday, December 21, 2006

More Thoughts On Emerging Markets

The Financial Times has another fascinating story today about how yield-differentials on emerging market debt are once more back at historic lows (see my other posts on this over the last few days):

Risk premiums for emerging market bonds fell to match their record low on Wednesday, only two days after the shock imposition of capital controls in Thailand reminded investors of the potential risks associated with the sector.

Investors measure the risk of emerging market debt by comparing their yields with those of US Treasuries, seen as the safest sovereign bonds. As measured by JPMorgan’s EMBI+, a benchmark indicator, that spread fell on Wednesday to 172 basis points – one basis point is equal to 1/100th of a percentage point – over US Treasuries, equalling a record low hit last in May.

So we are back where we were in May: before Iceland, Turkey, Hungary etc.

And why, may we ask, is this? Well, first of all let's look at this problem the other way round: why did they start to widen in the first place?

The EMBI+ last reached a record tight level of 172bp on May 1. The spread subsequently widened to 238 basis points by June 27, as investors worried that central banks were poised to tighten monetary policy more aggressively as oil prices approached $80 a barrel.

So we need to think about two things, oil prices and central bank tightening. Well oil prices have now stabilized somewhat (although if growth really takes off again somewhere they won't stay at this level for long), and equally importantly, despite the fact that Trichet promises to be extremely vigilant (although in December he was perhaps promising this a little less forcefully than he had been) the markets appear to be taking the view that the better part of this raising cycle may now well be over, and the real debate is moving to how soon rates in the OECD world will come down, and when they do do so, how fast will they fall.

Obviously Japan is going to be a key test case here, since if the BoJ cannot raise, or can only manage a belated token quarter point, the implications will be quite significant. While the jury is still out, noone seems to anticipate any large raise in the foreseeable future.

So where does that leave us? Well back with the attractiveness of emerging market debt, that's where it leaves us.

Analysts attribute the bullish performance in emerging markets to strong demand by investors hungry for yield. The class has become attractive as economies have improved in recent years, partly on the boom in commodity prices.

Now this last, lone little paragraph, in fact contains three very important points:

a) Pension funds are growing, so the need to find better yield than US treasuries only grows with them. As I keep saying I think low yield rather than the meltdown of anything is going to be the big pensions issue.

2) Emerging markets are growing as a whole slew of countries pass through their Demographic Dividend, while the low fertility culture spreads even faster than anyone ever imagined (globalisation and behavioural changes).

c) The commodities countries ride on the back of the other two, but again there are even more feedback mechanisms at work

So the big point is, if interest rates in the developed world start to trend down, then interest payments in India (and elsewhere) will also do so, which will indirectly aid productivity growth, since effectively capital deepening will get cheaper, apart from all those funds flooding in hungry for yield.

Now one last issue occurs to me, but this is more in the form of a question than anything. Thinking about it, isn't there a danger of this whole thing tipping over at some point, or at least of a tipping point being reached?

I mean, lets imagine that investors are not totally stupid, and that they do want to make money (innocent enough assumptions I would think).

So, even with all the froth, property in Delhi and Shanghai has certainly got a lot more to offer over the next 10 to 15 years in the way of return than property in Barcelona or London. Not only that, the respective currencies are going to rise significantly (Brad is certainly right here, Bretton Woods II is not sustainable indefinitely in these circumstances). On top of this a big chunk of the emerging world is now about to become a sure bet. I mean the risk of instability could be much greater in Italy or Japan in a not too distant future. So when markets finally wise up to this posibility, what the hell is going to happen? Could we see a higher risk premium being demanded for some developed economies? And if this outcome were to happen, just how far are we away from such a point?

One last untimely thought: what would be really interesting would be to understand the social/economic mechanisms by which India and China got to have such a large population, and what connection (if any) did this population explosion have with the early rapid growth of the now developed world. After all it is the sheer size of these two countries which now is going to produce all the turbulence, and while all that anti-imperialist stuff we still hear about in India may be just so much nonsense, there may actually be feedback mechanisms to be identified somewhere along the line here. I mean it may be more than mere coincidence that some get caught in a poverty trap that produces only children while others take off, but if there is a mechanism, what the hell does it look like?

1 comment:

Anonymous said...

Someone like me who worked in the Indian Financial sector few years back knows the hard fact that a very huge percentage of the Indian Financial Services Firms(even the Big guns) have grown over the past decades essentially through highly coterie based and non transparent systems ,also taking advantage of highly corrupt environments. It is easy to be impressed by the the statistics on paper, but do we really believe that the essentialy corruption based mindset in Indian Financial sector can be changed so easily, just by showing good growth numbers or new technology based systems etc..