Why have emerging market assets failed yet again?

One of my friends said, in the course of the month of March, that emerging economies have yet again proven that they are nothing high-beta (high octane) versions of developed country assets. In that sense, one could easily mimic an emerging market asset by leveraging up on developed country assets. That is from an investor perspective – an investor from a developed country. They do not offer any real diversification to an investor.

What about emerging markets themselves? Why have they just ended up being a turbo-charged versions of developed country assets – on the up and on the downside?

My guesses are as follows:

(1) With very few exceptions, emerging economies’ fortunes rely on demand from developed countries – either directly or indirectly.

(2) Very few have vibrant domestic economies, not just in terms of consumption share of GDP but also domestic production capabilities. Those who have the former do not have the latter and those who have the latter are dependent on external demand.

(3) They have liberalised capital flows too soon and without imposing any costs on fickle and short-term flows.

Much capital invested in developing countries is from overseas and doesn’t stick around when disaster hits — a record $83.3 billion fled last month from emerging stocks and bonds, the Institute of International Finance said this week.

Finally, there is usually little fiscal room to spend more and ease the pain. Currency depreciation makes it costlier to service overseas debt which by end-2018 amounted to 35% of GDP without counting China, the World Bank estimates. [Link]

That is partly because of their lack of (perceived) economic strength and clout and/or capture by western discourse and much else.

(4) In good times, developing economies have not dedicated efforts to strengthening their defences and economic resilience. They do not build buffers.

(5) There is no multi-polarity in global reserve currencies. Of course, if we have them, it could be a mixed blessing for other reasons.

(6) There is no independent economic thinking in the sense that emerging economies do not put in the effort or scholarship to develop economic development approaches suited to their context and history, drawn from the best and the worst of their own experiences and that of others.

(7) Those who do are not encouraged or they are captured eventually. The system (establishment), in thrall to the received wisdom of the West (or worse) do not let them invest the intellectual effort required to build such indigenous and appropriate economic models. Consequently, an intellectual ecosystem that would make it easier to develop such a tailor-made approach is not created.

IMF advice on capital flows

Kristalina Georgieva, Managing Director of the International Monetary Fund, has written an article for FT on providing sound policy advice to emerging economies. It is conceptual in nature. Nothing wrong with the piece. To the extent it signals intellectual openness on the part of the Fund, it is welcome. 

The elephant in the room is the monetary policy pursued by the developed world. That has become a big and sizeable fetter on the policy options available to developing countries, with their spillover effects. IMF is unable to do much about them, if at all.

For the countries pursuing such policies, their efficacy – taking into consideration the impact on asset markets, real economy and the society at large – is in doubt. At the minimum, a honest evaluation is needed. But, central banks are resistant. Further, governments in those countries are not paying due regard to the long-term effects of such policies – a well-known ‘time inconsistency’ problem.

See this article on the housing bubble in Ireland and its impact on the Irish elections. The role played by QE pursued by the European Central Bank is highlighted.

Unless this is addressed, whatever advice IMF offers emerging economies will be band-aids. Well, band-aids have their uses too.

Hope over logic

Just happened to come across this news-story in Bloomberg. According to stockbrokers and investment banks, emerging markets will have better times in 2019 than in 2018. Simple rule of thumb is that if forecast did not materialise, simply forward it to the following year!

Correction in American stocks has just begun. There will always be whiplash rallies as happened on Monday. Corporate credit and leveraged loans markets are dangerously unstable. The risks in these markets are yet to play out.

Political risk in emerging economies is not to be discounted. Almost all the major developing economies have fragile political stability now – Turkey, Brazil, South Africa, India and China – for different reasons.

In this milieu, it is hard to nod vigorously to this cheery prediction which is, of course, the default option for these institutions.

On the contrary, if they had turned negative, it would be rather necessary to seriously examine the possibility that these markets had bottomed out.

Reinhart on EM

She makes some interesting points:

There’s a whole range of sub-Saharan African and Middle Eastern countries that have become indebted to China. It’s a very opaque area. Countries like Angola, if you factor in Chinese loans, their external debt is 20 percent higher than what official data suggest.

The point above is that as everyone scrambles to get hold of dollars to repay (creditors too – including sovereigns like China – will demand repayment, banks will refuse rollover or do so only on stiffer terms and thus aggravate the dollar shortage.

“There used to be this larger barrier between internal and external debt. That’s been blurred, as we see with Argentina. Internal debt is increasingly being held by non-residents, making for bigger spillovers.”

I am glad she made this point because many miss this or refuse to see this. When non-residents hold domestic debt, the currency of denomination of debt is as good (or, as bad) as foreign currency.

If you look at capital flows to EM, it’s also closely connected to volatility. It’s not just that interest rates were low but volatility was non-existent for a while. Volatility is on the rise and neither of those bode well for inflows to EM.

I think she too is making the mistake of association with causation. Low volatility does not cause debt flows to EM. Low volatility and debt flows to EM are parts of the same phenomenon of risk appetite. When risk appetite turns cautious, low volatility ceases and it rises. EM debt flows reverse.

These snippets are taken from the Bloomberg story.

STCMA – 19 July 2017

(1) Shock rise in China’s shadow banking enrages Xi Jinping. Quite why it should be shocking is unclear to this blogger. The interesting tidbit in the story is this:

… the shadow banking nexus is bigger than all other regular activities of the lenders put together. Regulators had thought it was equivalent to 42% of on-balance sheet business at the end of 2015. They have revised this drastically, admitting that it reached 110% by the end of last year.

(2)  Have the Economic Constraints on China’s Geostrategic Ambitions diminished? That is an interesting question to ask. But, as Brad Setser note,s there is room to disagree with the author’s recommendations.

(3) Headlines that tell the story together. No need for lengthy analysis

China’s Xi orders debt crackdown for state-owned groups [Link]

Chinese purchases of overseas ports top USD20bn in past year [Link]

(4) Barry Eichengreen on the 20th anniversary of the Asian crisis:

… if the emergence of China signifies how much has changed, it is also a reminder of how much remains the same. China is still wedded to a model that prioritizes a target rate of growth, and it still relies on high investment to hit that target. The government maintains liquidity provision at whatever levels are needed to keep the economic engine humming, in a manner dangerously reminiscent of what Thailand was doing before its crisis.

Because China’s government relaxed restrictions on offshore borrowing faster than was prudent, Chinese enterprises with links to the government have high levels of foreign debt. And there is still a reluctance to let the currency float, something that would discourage Chinese firms from accumulating such large foreign-currency-denominated obligations.

China is now at the same point as its Southeast Asian neighbors 20 years ago: like them, it has outgrown its inherited growth model. We have to hope that Chinese leaders have studied the Asian crisis. Otherwise they are doomed to repeat it.

(5) The real Takeaways from the weekend meeting in China:

(i) Support the real economy
(ii) reduce lending costs for the real economy
(iii) relegating financial opening up and currency reforms to the backburner – no more liberalisation. Concern over capital flows dominates.

The rest is all smoke and mirrors.

(6) Singapore blinks. [Link]

(7) Bill Gates cautions Europe on its open door immigration policy. Good stuff from the man. Speaking the truth.

(8) China’s Growth masks Unresolved Debt and Real-Estate Problems. Who knew?

(9) California confronts solar power glut with novel marketplace

(10) Conviction of former President of Brazil. I think Brazil is doing a far better job of cleaning up its politics than many other countries, including the so-called developed countries.

Volatility and financial crises

I just finished teaching a course titled, ‘Advanced Quantitative and Economic Analysis’ for students of the Master of Science Programme in Applied Finance at the Singapore Management University, on Friday. I had talked to them in the last two sessions about how long periods of stability breed instability through the risk-taking channel. This is the hypothesis of Hyman Minsky.

I was pleasantly surprised to find a paper published by the Federal Reserve Board in October 2016 on this topic. The paper is:

Danielsson, Jon, Marcela Valenzuela, and Ilknur Zer (2016). “Learning from
History: Volatility and Financial Crises,” Finance and Economics Discussion Series
2016-093. Washington: Board of Governors of the Federal Reserve System,
https://doi.org/10.17016/FEDS.2016.093.

While the common view is that volatility directly affects the probability of a crisis, this has proven difficult to verify empirically. In what we believe is the first study to do so, we find direct empirical evidence that the level of volatility is not a good indicator of a crisis, but that relatively high or low volatility is. Low volatility increases the probability a banking crisis, both high and low volatility matter for stock market crises, whereas volatility{in any form{does not seem to explain currency crises.

We further use the credit-to-GDP gap as a proxy for risk-taking, and find that low
volatility significantly increases risk-taking. This is very much in line with what theory predicts and provides strong evidence for Minsky’s instability hypothesis and his famous statement that \stability is destabilizing”. Low volatility induces risk-taking, which leads to riskier investments. When those turn sour, a crisis follows.

Finally, we find that the relationship between volatility gap and the incidence of a crisis becomes stronger over time, consistent with the observation that stock markets have grown in importance over the 211 year sample.

What they say on page 6 about stock markets, low volatility and crises is very interesting:

Third, since our 211-year sample contains a variety of economic systems, market structures, and technological developments, it is of interest to examine the volatility-crisis relationship over key sub-periods of the sample. The relationship between financial market volatility and the incidence of a crisis becomes stronger over time – not surprising considering that prior to World War I, stock markets, and hence market volatility, played a much smaller role in the economy than they would later. The relationship weakened again during the Bretton Woods era when financial markets and capital flows were heavily regulated, and became especially strong since.

The emphasis above is mine. The policy implications are obvious. We need to regulate capital flows. Keynes was dead right in that respect. That is why it was both surprising and disappointing that Vijay Kelkar and Ajay Shah, in their advice to the government on managing the aftermath of demonetisation, batted for capital account convertibility. Not only was it unrelated to the issue of demonetisation but it is also counter to the mounting evidence that it does not add to but subtracts from economic welfare.

Indeed, India should consider not only retaining the short-term transaction tax in financial markets but think of expanding its scope and enhancing the rate of such taxation!

Somethings do not add up

Doug Noland writes in his weekly credit bubble bulletin as follows:

Let’s return to election late-night. I doubt traders and the more sophisticated market operators will easily forget what almost transpired. It’s worth noting that while S&P500 futures and the Mexican peso were collapsing, the Japanese yen was in melt-up. In just over two hours, the dollar/yen moved from 105.47 to 101.22 – an almost 4% move. Meanwhile, EM and higher-yielding currencies were under intense selling pressure – the Brazilian real, South African rand, Turkish lira, Colombian peso, Australian dollar and New Zealand dollar (to name a few). At the same time, gold surged from $1,270 to $1,338. Crude sank 4%. Global markets were on the brink of a serious speculative de-leveraging episode. [Link]

Gold has sunk to USD1229 in the spot market by close of Friday. Japanese yen is back at 106.685. Stocks made new highs and held on to them on Friday. But, at the same time, EM stocks, currencies and bonds are hurting. Risk aversion is partial. U.S. stocks and dollar are exempt. So, there is a portfolio reallocation from EM assets, US bonds and gold to US stocks. I am not convinced it makes sense.