It’s time to reappraise global economy risks

The current spotlight on hedge funds has inspired many comparisons with the collapse of Long Term Capital Management in 1998. There are plenty of differences between 1998 and now, but perhaps the biggest of them is that in 1998, the contagion spread from East Asia via the Asian crisis initially to Russia and from there to the US, leading to the collapse of the Nobel Laureate-run hedge fund. This time, it’s the US mortgage and credit system that is the epicentre of the disease and the contagion is spreading to the rest of the world from the US.
That change illustrates the transformation in the world economy in the 10 years since the Asian crisis. Emerging markets have always been seen as risky places to do business and fund flows to emerging markets have tended to rush back to the developed countries at periodic intervals. That’s what happened in 1994, when interest rates started going up in the US, and in 1997, as a result of the Asian crisis. Forget emerging markets, even Japan was suspect after the market there blew up in the late eighties. In the 21st century, however, things seem to have changed substantially. First, the tech bubble was a US-centric, specifically Nasdaq-centric, phenomenon that spread to other markets.
The bursting of that bubble affected the US the most—the Nasdaq is still nowhere near the heights it scaled at the time. Next, in the current four-year-old bull run, every wobble originated in the US market, the effect of either slowing US growth or higher interest rates. And the current panic is an exclusive made-in-USA affair, arising out of bad loans originating there and the result of falling house prices in that country. Instead of emerging markets, it turns out that the origins of latter-day risk lie in the US.
Whether it is dodgy US companies, like Enron or WorldCom, or a sluggish economy, or problems in the financial sector, the US is now more risky for investors than many emerging markets. As for growth, of the 56 countries whose GDP is tracked every week by the Economist magazine, only three are forecast to have a growth rate lower than that of the US this year.
That doesn’t yet translate into emerging market immunity from whatever happens in the US. In the last few days, many emerging stock markets have been hit badly by the withdrawal of foreign investors. With so much money originating from the US and with the received wisdom still of the firm view that emerging markets are high-risk assets, funds flow out at the slightest hint of a panic, regardless of where it originates. And with global markets so closely correlated these days, that’s hardly surprising. As a hedge fund manager pointed out, the Nifty is nothing but the Dow on steroids. Of course, not all emerging markets are equal. In India, the fact that our markets are far more diversified than other Asian markets has long been an argument for justifying the premium in valuation. And several emerging markets boosted by the carry trades have very vulnerable current accounts, Turkey and several East European countries being examples.
But the last few years have, in general, seen plenty of improvement in the fundamentals of emerging economies, a fact brought out clearly by the higher sovereign ratings they now command. Fiscal deficits have been cut and current account surpluses built. A mountain of foreign exchange reserves has been accumulated. Domestic savings rates have increased. At least a part of the compression in spreads of emerging market bonds can be justified by these improvements. And, despite the slowdown in the US economy, growth has been very strong in the emerging markets.
These factors have led to many voices being raised in defence of the emerging markets asset class. Guillermo Mondino, head of emerging markets strategy at Lehman Brothers, for instance, writes in a research note that “in a few weeks, emerging market investors may emerge reflecting that news about their market’s decline were greatly exaggerated.” And further, “Fundamentals in the asset class remain, by and large, very solid, as reflected in the long string of positive rating actions during the past six months. “Medium- to long-term probabilities of default are lower and declining. Our own balance of payment crisis indicator, `Damocles’, also suggests low risk and an improving trend. Furthermore, very few countries are critically dependent, for the financing of their fiscal needs or their balance of payments, on market access in the short term.”
CLSA’s Christopher Wood, in the latest issue of his newsletter, Greed & Fear, writes that the problems in US-originated credit will in the longer term be a gigantic buying opportunity for Asian equities, although there will inevitably be pain in the short term. Wood says that “such a primarily US-focused financial panic will do nothing to unwind the secular asset reflation story in Asia” and that “Asia and other emerging markets will be the likely bubble beneficiaries of the coming Fed easing.” The reference to “bubble beneficiaries” is interesting and refers to the theory that the world has seen a series of financial bubbles in recent times, as money flows shift from crisis centres to other asset classes and other parts of the world. For instance, it was the flight of funds from Asia back to the US after the Asian crisis that is credited for creating the tech bubble there. It’s unlikely that the reverse will happen as a result of the current panic. But the time is now ripe for a reassessment of where the risks in the global economy lie.