ab Global Economics Research
Emerging Markets UBS Investment Research Hong Kong Emerging Economic Perspectives
The Global Liquidity Primer 28 October 2010
www.ubs.com/economics
Jonathan Anderson Economist [email protected] +852-2971 8515
This is installment #13 of our Emerging Market Perspectives series
• Where does global liquidity come from?
• Why is it flowing to emerging markets?
• Are we already talking about a massive “wall of cash”?
• And do global flows threaten to change the way EM markets work?
• Will capital inflows force EM currencies up? Will they cause inflation?
• Are we headed for rampant capital controls?
• How does “sterilization” fit in?
• Are asset markets already overheated? And are bubbles developing?
• Above all, how do investors position for this new environment?
This report has been prepared by UBS Securities Asia Limited ANALYST CERTIFICATION AND REQUIRED DISCLOSURES BEGIN ON PAGE 45.
Emerging Economic Perspectives 28 October 2010
Introduction and summary
In the past few months, almost every investor we meet has been preoccupied with the question of “global liquidity” – and its impact on the emerging world. Global growth is expected to slow, and the US Fed is publicly discussing a new round of quantitative easing. Meanwhile, capital flows into emerging markets have recovered dramatically over the past 12 months; EM asset markets have recently started to outperform by wider margins, and at the same time a number of countries have either imposed capital controls or are at least discussing them.
In short, there’s a general sense that the global “game” is now changing, and that global liquidity could be an overwhelmingly dominant theme for EM economies and markets over the next year. Where is the money coming from? How do we measure “liquidity”? How much is rushing in to EM? Are we already seeing asset bubbles? Could capital inflows overwhelm currency pegs? Cause high inflation? Should we expect pervasive capital controls? And this list of questions goes on from there.
In this report we want to take a step back and walk through key details, starting from an explanation of the very basics and working through the above list of questions.
Now, we have two disclaimers right up front: First, this is a long report. And second, you don’t necessarily have to read it. We’ve distilled our key findings into three summary conclusions; if these make perfect sense, then you may not need to venture further. If they don’t then we recommend looking into the individual chapters below for further analysis.
Summary conclusions
1. We are currently in a world of strong global liquidity and thus higher capital flows into the emerging world – and could well remain here for a good while to come.
As long as we have (i) low developed interest rates, (ii) low volatility and strong risk appetite, and (iii) high structural growth differentials between developed and emerging markets, this is sufficient to bring about a significant portfolio reallocation in favor of higher returns in the emerging world. And crucially, this doesn’t really depend on the Fed or other advanced central banks actually printing money; even if we don’t get the much-touted “QE2”, the medium-term drivers of liquidity flows are still very much in place.
The main risks to this scenario would either be a downside global shock such as renewed sharp recession or sovereign default – or a shift in developed expectations back towards inflation and higher growth.
2. Global capital flows are not a “game changer” for EM macro conditions today.
Despite widespread investor concerns, the fact is that the current rush of capital into EM markets is too small to destabilize the overall macro situation. I.e., we don’t expect currencies to be “knocked off” their current quasi-pegged path; emerging inflation is not about to rise dramatically in the face of massive monetary inflows; central banks in general are not running out of sterilization options, and asset markets are still well-behaved for the most part.
Tensions still remain, of course. The above statements do not hold in every specific case; some countries are already beginning to impose targeted capital controls and this practice will likely continue going forward, especially as short-lived speculative waves intensify. So in our view there should be plenty of headline new risk to keep investors and markets guessing. However, again, we don’t see a strong challenge to the current “EM model” as a whole.
3. The real risks come further out, with potential asset bubbles and medium-term inflationary pressures at the forefront.
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The longer we remain in an environment of large, one-way global capital flows, however, the greater the potential risks become. The last time the world found itself in similar conditions was in 1989-94, with synchronized developed recessions, sharply falling global interest rates, continued strong growth in Asia and Latin America and sustained large-scale capital flows, and this led to two destabilizing trends:
First, widespread equity bubbles. Equities are the asset class most directly exposed to upside pressures from global buying, and it’s hardly a coincidence that the first half of the 1990s saw the biggest, most pervasive equity bubble in emerging market history – one that occurred, incidentally, against the backdrop of nearly flat global markets over the same period. This, of course, jibes well with our strong overweight on EM equity markets today, but we would rather not see markets get overheated to the same degree as back then.
And second, global flows likely contributed indirectly to the “second wave” of Asian instability in the latter part of the 1990s, when excessively loose domestic credit conditions fed into sharply rising leverage and property market exposure, ending in the Asian financial crisis. The logic here is that high capital inflows and the “global bid” on yields keep EM interest rates lower than they should be, given more buoyant growth conditions compared to developed markets, imparting a longer-term inflationary bias into the system.
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What do we mean by liquidity?
It’s about printing money ... but it’s not about printing money.
We begin our primer at the most basic and fundamental level, with a few short words on the nature of global liquidity. Perhaps the most common fallacy we hear from investors is that “The Fed is printing money, and this money is flowing to emerging markets.”
At risk of stating the obvious, the US Fed, the ECB, the Bank of England and the Bank of Japan have all created extraordinary amounts of money over the past two years – but that money hasn’t actually gone anywhere, much less making its way to the EM world.
As shown in Chart 1, the stock of high-powered “base” money in the advanced G3 economies – money printed by central banks as they expand their balance sheets, and transferred to the commercial banking system – shot upwards from end-2008 through 2009. However, over the same time bank credit growth collapsed (the blue line in the chart), and has yet to show any meaningful signs of upturn; the outstanding stock of broad money in these countries is also nearly flat.
Chart 1. No growth here
G3 average growth rate (% y/y) 25%
Base money 20% Private credit Broad money M2
15%
10%
5%
0%
-5% 2003 2004 2005 2006 2007 2008 2009 2010
Source: Haver, CEIC, IMF, UBS estimates
Put in economic terms, with standard money and credit transmission mechanisms essentially broken and implied multipliers careening downwards, all that “money” is merely bottled up in commercial bank excess reserve accounts and there has been almost no leakage into the broad money supply or the real economy.
A better definition
This doesn’t mean that developed central banks aren’t responsible for capital flows to EM, of course. In our view central banks do indeed play a fundamental and crucial role in the process. It’s just that the real transmission mechanism has little to do with physical money creation itself; rather, it comes through interest rates and the distorting effects of quantitative monetary policy on risk appetite.
The first point to make here is that we don’t actually need new physical money or liquidity creation to sustain large-scale flows of capital from developed to emerging markets (or, for that matter, large-scale movements of capital into global risk assets). Even the most rudimentary count shows that the advanced world has more than US$150 trillion worth of financial wealth in domestic bonds, equities and money – a sum many, many multiples larger than the total investable size of all liquid EM asset markets. Compared to this figure, even the unprecedented, historic US$1 trillion “explosion” of the US Fed balance sheet
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simply fades away behind the decimal point, as does any new quantitative injection that might be carried out under so-called QE2.
In other words, all we need for capital flows to occur is for investors to reallocate existing funds away from cash or developed assets and into emerging markets.
And when viewed in this light, the true definition of liquidity – again, as it affects the EM universe – is the underlying set of factors that allows this portfolio reallocation to take place.
Part 1 – Interest rates
What are these factors? This can be a very complicated topic, but at the simplest level there are essentially two in our view. The first is the level of interest rates in advanced economies, i.e., the cost of borrowing funds for investment purposes and the return to holding alternative safe assets. This is a fairly obvious point and we don’t want to belabor it here; the pattern in Chart 2 below speaks for itself.
Chart 2. Interest rates at record lows
Average G3 interest rates 6.0% Short-term rate 10-year yield 5.0%
4.0%
3.0%
2.0%
1.0%
0.0% 00 01 02 03 04 05 06 07 08 09 10
Source: Haver, CEIC, Bloomberg, UBS estimates
Of course, from the point of view of the Fed and other developed central banks they may be acting primarily as a lender of last resort, buying up impaired assets in order to support markets, allowing the private sector to carry out continued delevering and/or helping the public sector support the economy. But very little of this activity is directly relevant for flows into the EM world. Instead, the key issue is really that these operations keep short-term interest rates close to zero (and generally provide a large buffer of excess free reserves in the commercial banking system to ensure that they stay there).
Part 2 – Volatility and risk appetite
And for our purposes, therefore, the real importance of the current debate over the need for further US Fed easing is precisely how it affects expectations about the duration and stability of a low-interest rate environment.
Which brings us to the second critical factor in our liquidity equation, i.e., risk appetite.
There is a crucial difference between (i) having zero or near-zero interest rates against a backdrop of tremendous fragilities and a high probability of renewed financial collapse or sovereign crises, or for that matter the threat of high inflation and sudden tightening, and (ii) having zero interest rates in an environment of stable if moderate recovery, strong visibility on future trends and growing confidence in the authorities’ ability to prevent further “tail” events.
In the first case money may be nearly “free” but appetite for risk would also be very low, with a strong preference for safe-haven holdings; by contrast, in the second case you would be much more likely to see funds flowing to risk and growth assets, including those in EM.
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How do we measure risk appetite? In some cases we can directly observe investor demand for safe vs. risk assets – the price of gold, for example, or net flows into cyclical high-beta equity sectors – but for the most part we prefer to look at volatility, or to be precise the implied volatility in options pricing across asset classes (for example, most readers will likely be familiar with the VIX index, commonly known as the “fear index”, which measures implied volatility in the US stock market; a high level of volatility indicates strong risk aversion, while a low reading indicates greater appetite for risk).
As it turns out, our UBS equity, fixed income and FX strategy teams compile daily composite indices of market risk appetite, including a range of volatility and positioning indicators for each asset class (see Back to Risks and Flows, EM Daily, 20 October 2010 for full details on the composition of these indices). In Chart 3 we have aggregated their results into a summary “total risk index”; as you can see, over the past 12 months investor appetite has recovered dramatically from the collapse of confidence in 2008, and despite periods of higher volatility and choppy market performance this year we still see relatively strong risk positioning and pricing today.
Chart 3. UBS risk indicators
Risk appetite index (15-day moving average) 1.5 Equity FX 1.0 Fixed income OVERALL
0.5
0.0
-0.5
-1.0
-1.5
-2.0 Stronger risk aversion
-2.5 2005 2006 2007 2008 2009 2010
Source: UBS estimates
In other words, underlying liquidity – as we define it – has rapidly returned to markets. And crucially, despite the fact that we are working with a very basic definition, in the past few years there has been a virtual one-to-one correlation between our risk index and the actual level of net portfolio capital flows to the emerging world (see Chart 4; we will define our measure of capital flows further below).
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Chart 4. Risk and flows
Risk index % of GDP (3mma) 1.00 6%
0.50 4%
2% 0.00
0% -0.50 -2% -1.00 -4%
-1.50 UBS total market risk index (LHS) -6% Net portfolio capital inflows (RHS) -2.00 -8%
-2.50 -10% 2005 2006 2007 2008 2009 2010
Source: CEIC, Haver, IMF, Bloomberg, UBS estimates
But can it continue?
To sum up, from an EM perspective our fundamental working definition of global liquidity has little to do with the actual amount of money entering into circulation. Rather, in the most simplistic sense it is “interest rates plus volatility”; these two factors that can push large amounts of funds into risk and growth assets – and, as we will argue, large amounts into the emerging world.
From Chart 4 above it’s clear that conditions have been very favorable for risk trades and EM flows over the past year. But can it continue? And what are the salient risks?
A complete answer is well beyond the scope of this report – but if there is one conclusion that comes directly from our analysis below, it is that the main risks come from the global side rather than from EM- specific macro trends. As we will show, both balance sheet conditions and the stability of the underlying growth story are more favorable in emerging markets. Meanwhile, in our view the potential for unpleasant shocks remains much greater in advanced economies.
What kind of shocks should investors watch out for? We would highlight three candidates: First, a significant, abrupt drop in economic activity that leads to renewed fears of a painful “double-dip” recession. Second, more severe sovereign stress or outright default, most likely in the European periphery. And third, any sign of unexpectedly strong inflationary pressures that might shake out long-term bond yields and swing market expectations towards renewed tightening.
At present, our global team’s forecasts don’t include any of these three trends; instead, we are looking for a gradual slowdown in activity over the coming few quarters and continued disinflation, combined with a further round of monetary easing in the US and perhaps in other cases as well. I.e., our base-case scenario is that global liquidity conditions remain favorable to risk-related flows going forward. But needless to say market perceptions can change very quickly, and this bears close watching.
The “great carry trade”, and blowing bubbles
We have a few final notes before we move on. The first point is that when we talk about global liquidity and EM flows, we are essentially talking about a return to the pre-crisis global “carry trade” – except that this time virtually the entire developed world is acting as the funding source rather than just zero interest- rate Japan. And this, of course, raises the same concerns about the eventual unwinding of the trade that we saw in 2007-08 (or, for that matter, in 1994). We’ll have much more to say about this in further sections below.
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To say almost the same thing from a different angle, one of the most common critiques of the current US and G3 monetary policy stance is that “the Fed is blowing bubbles”, not so much in local markets but rather in global commodities and emerging market assets. As we will show below, this is not really the case today as far as most EM markets are concerned – but if current conditions continue over the next year or two we see a much stronger probability that the situation can turn from one of strong-ish capital reflows and buoyant markets to outright overpricing and unsustainability.
Is it all about the dollar?
Second, in our experience most investors tend to think about flows with respect to the US dollar, i.e., that a weak dollar “drives” funds to emerging markets and a stronger dollar takes liquidity back. And sure enough, if we take Chart 4 above and superimpose the nominal US dollar trade-weighted index against global risk and EM flows, the correlation is immediately evident (Chart 5).
Chart 5. Risk and the dollar
Risk index % of GDP (3mma) 1.00 6%
0.50 4%
2% 0.00
0% -0.50 -2% -1.00 -4%
-1.50 -6% UBS global risk index Trade-weighted dollar index -2.00 -8% Net portfolio capital inflows (RHS)
-2.50 -10% 2005 2006 2007 2008 2009 2010
Source: Haver, CEIC, IMF, UBS estimates
However, in broadest terms this correlation doesn’t necessarily have to hold. Again, in our view the most fundamental drivers of flows to EM are the level of G3 interest rates as a whole and the general level of global risk, period. At present the dollar is seen as a global safe haven asset, which means that periods of risk retrenchment generally lead to a stronger dollar, while rising risk appetite tends to mean dollar outflows. But if this relationship were to shift over time, we believe EM flows would remain correlated with risk metrics – and not with the dollar per se.
Are emerging markets themselves driving the boat?
A final popular line of argument holds that emerging markets themselves are the real driving factor behind the whole liquidity story, i.e., that by chronically intervening in their exchange rates and recycling massive excess savings into the G3 economies, emerging countries push down global interest rates and push up the global money stock – and, by implication, that a move to greater currency flexibility in EM could have devastating implications for global market conditions.
It’s certainly true that emerging market economies have been heavily managing currencies over the past decade (and indeed, this is very much “business as usual” for the EM world), but we’re not sure we see much merit in the broader argument above, for three reasons.
To begin with, as we showed in The Curmudgeon’s Guide to Global Rebalancing (EM Perspectives, 22 March 2010), emerging surpluses have fallen visibly over the past few years and are no longer such a significant part of the global economic story. Second, we already saw above that the physical amount of
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credit and money in circulation in the developed world is barely rising at all. And third, while EM purchases of government securities may have a more concentrated impact on long-term yields in the US and Europe, in our view it is the impact of developed central banks in anchoring short-term rate expectations that plays the most important role in underlying liquidity conditions.
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Why emerging markets?
Three good reasons
So far so good; in the section above we defined the global liquidity backdrop and established that current conditions appear very supportive for capital movements into risk assets. We’ll discuss the actual pattern of flows further below, but before we do we need to address one more fundamental question: Even if overall liquidity conditions are favorable, why should we expect funds to flow specifically to the emerging world?
The short answer is that emerging markets fulfill three criteria. First, for most of the past decade the EM universe has offered the best growth and return opportunities in the global economy, and this continues to be the case today. Second, emerging assets are traditionally highly correlated with developed risk appetite. Third, and most important, relative balance sheet and performance gaps continued to widen through the recent crisis, and in our view EM economies are in the midst of an ongoing medium-term rerating in view of lower implied risks and greater stability.
In other words, whether we look at relative returns, the correlation to risk conditions or prospects for structural portfolio rebalancing, emerging markets stand out as perhaps the most obvious candidate for liquidity-related global capital flows.
EM vs. DM – balance sheets
We’ve been through the structural underpinnings of the EM growth story a number of times before in these pages, and most thoroughly in The Real Decoupling (UBS EM Perspectives, 17 August 2009), so we won’t go into too much detail here. But it’s nonetheless helpful to review a few key themes and charts.
The first concerns the nature of decoupling itself, and here we begin with balance sheets. The blue and green lines in Chart 6 below show our aggregate macro “stress index” for the emerging and developed worlds respectively; as a reminder, this is a rough view of the state of external debt and deficits, domestic bank leverage and public finances, with a high reading indicating high stress levels and a low figure indicating clean balance sheets (see the Real Decoupling report for full details).
Chart 6. Aggregate balance sheet stress index
Total stress index Total stress index 10 9
9 8
8 7 7 6 6 5 5 4 4 3 3 2 2 Emerging markets Developed markets (RHS) 1 1
0 0 1960 1970 1980 1990 2000 2010
Source: Haver, CEIC, IMF, World Bank, UBS estimates
The divergence between EM and advanced economies over the past 20 years could not be more glaring. The emerging world went through a dramatic wave of extreme macro stress, financial crises and
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subsequent delevering during the 1980s and 1990s – and as a result entered the last decade with the most favorable balance sheet conditions in its history, a point that remains broadly true today.
For the advanced bloc, meanwhile, just the opposite is true; the previous decade was mostly a period of unremitting debt and leverage creation, and many countries now face continued structural delevering and balance sheet repair pressures going forward.
EM vs. DM – growth
And the impact on relative growth performance has been equally dramatic. During its main crisis period from the mid-1990s through the early 2000s, the EM world struggled to show any trend outperformance at all in terms of real GDP or industrial production growth (Charts 7 and 8), completely counter to the “normal” state of affairs in the 1960s and 1970s, when poorer countries did grow much faster than their advanced counterparts.
However, starting in 2002 – i.e., once the bulk of emerging markets had undergone a full balance sheet cleanup – the situation changed radically. Overall emerging growth accelerated back to historical peak levels, and the real growth gap between EM and advanced countries widened to an impressive four to five percentage points. Moreover, despite the greatest collapse of global trade and financial flows in the post- war era that gap remained absolutely stable at around four percentage points through the 2008-09 downturn and all through the subsequent recovery.
Chart 7. EM vs. developed GDP Chart 8. EM vs. developed industrial production
Real GDP grow th (mid-w eighted, % y/y) Industrial production grow th (mid-w eighted, % y/y) 8% 15%
6% 10% 4%
5% 2%
0% 0%
-2% EM -5% Dev eloped EM -4% Dev eloped
-6% -10% 95 97 99 01 03 05 07 09 95 97 99 01 03 05 07 09
Source: Haver, CEIC, IMF, UBS estimates Source: Haver, CEIC, IMF, UBS estimates
In short, we’ve learned two things about EM economies over the past half-decade. The first is that global “betas” remain very high and there is no sense of absolute delinkage between the emerging and developed worlds in terms of economic cycles.
And second, however, there has been a tremendous delinking of the underlying “alphas”, i.e., the relative trend pace at which these two blocs can grow.
EM vs. DM – credit and inflation
Moreover, the alpha decoupling of EM markets is not just valid for physical indicators; it is evident in nearly every macro variable we cover, and most critically in the pace of credit expansion and the average rate of inflation in Charts 9 and 10.
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Chart 9. EM vs. developed credit growth Chart 10. EM vs. developed inflation
Private sector credit grow th (% y/y) CPI inflation (% y/y) 30% 12%
EM 25% 10% EM Developed Developed 20% 8%
15% 6%
10% 4%
5% 2%
0% 0%
-5% -2% 01 02 03 04 05 06 07 08 09 10 01 02 03 04 05 06 07 08 09 10
Source: Haver, CEIC, IMF, UBS estimates Source: Haver, CEIC, IMF, UBS estimates
The ongoing rerating of the emerging world
All of the above shows that there has been an ongoing rerating of emerging economies over the past decade – and crucially, we expect this process to continue going forward as well.
Why? Well, again, because the decoupling of underlying trend growth is almost perfectly explained by the divergence in fundamental macro balance sheet conditions, as shown vividly in Chart 11.
Chart 11. Balance sheet stress and EM outperformance
Percentage points (3yma) Index level (inverse) 6% 0
EM/Developed growth differential 1 5% EMl stress index (RHS, inverse scale) 2 4% 3 3% 4
2% 5
6 1% 7 0% 8 -1% 9
-2% 10 1960 1970 1980 1990 2000 2010
Source: Haver, CEIC, IMF, World Bank, UBS estimates
In other words, this is a structural phenomenon ... or, better put, a long-term phenomenon. In our view the EM world will inevitably “lever up” over the coming decade while developed countries clean up their own balance sheets, which implies an eventual narrowing of the current gap in the chart above. But the key here is that this is a process that occurs over many years, and in the meantime we expect steady and significant outperformance from emerging markets.
You can see this very clearly in the current public discussion on global prospects. For example, Chart 12 shows the five-year IMF World Economic Outlook forecasts for real GDP growth by region, perhaps one of the best gauges of the medium-term market consensus. Every emerging region is expected to grow somewhat slower than during the 2003-08 boom, but still much faster than in the 1998-02 crisis years – and even more important, much faster than the developed world.
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Chart 12. IMF growth forecasts by region
Real GDP growth rate (% y/y) 10%
9%
1998-2002 8% 2003-08 IMF Forecasts (2011-15) 7%
6%
5%
4%
3%
2%
1%
0% US Eurozone Japan Low-income Latin EM Europe Middle East Africa Asia America
Source: IMF, UBS estimates
Alpha decoupling and market returns
And this brings us to our concluding point: As we have argued consistently in earlier research, it is precisely the higher EM alpha that drives structural outperformance in market returns.
You can see this clearly in equity markets. Emerging corporate earnings (as measured by the respective MSCI indices) actually lagged those in the developed world from 1995 to 2002; since 2003 EM earnings begin to rise more rapidly – and since the onset of the crisis we have seen a visible delinkage in the level of profits generated in the emerging universe compared to advanced countries (Chart 13).
Chart 13. EM vs. developed earnings Chart 14. UBS “GEM Inc.” forecasts
Implied earnings (1995-2005 avg=100) Adjusted net income, constant UBS coverage universe (2007=100) 350 160
140 300 MSCI Wor ld Developed countries MSCI EM Emerging markets 120 250
100 200 80 150 60
100 40
50 20
0 0 1995 2000 2005 2010 2003 2005 2007 2009 2011E
Source: MSCI, UBS estimates Source: UBS estimates
This is equally true when measured from the bottom up; every quarter our UBS strategy teams compile income statements and balance sheets for “World Inc.” and “GEM Inc.”, an extremely large and consistent population of companies under coverage in the developed and emerging worlds respectively, with both historical and forecast data as well (see “GEM Inc.” vs. “World Inc.”, EM Daily, 24 August 2010 for further details). As shown in Chart 14, aggregate EM earnings have begun to outperform sharply since 2008, and based on our current corporate-level forecasts that earnings gap is expected to widen further in the next 18-24 months.
Turning to interest rates, the two charts below essentially speak for themselves. There is still a good bit of correlation between rate movements in the two economic blocs – but whether we look at short-term rates
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or long yields, the average return in emerging markets is roughly 400 basis points higher than in the developed world.
Chart 15. Short-term interest rates Chart 16. Long bond yields
Short-term interest rate (percent per annum) Long bond yield (percent per annum) 10% 10%
9% Developed 9% Developed EM 8% 8% EM
7% 7%
6% 6%
5% 5%
4% 4%
3% 3%
2% 2%
1% 1%
0% 0% 03 04 05 06 07 08 09 10 03 04 05 06 07 08 09 10
Source: CEIC, Haver, Bloomberg, UBS estimates Source: CEIC, Haver, Bloomberg, UBS estimates
In short, we have all the markings of a very potent cocktail at work here. Not only are interest rates at unprecedented low levels in virtually all of the advanced markets; we also have structurally sound balance sheets and visibly higher returns across all asset classes in the emerging market universe. And if anything the relative balance has been tilted further in favor of EM since the crisis. No wonder that capital has been flowing in one direction when risk appetite is even marginally strong.
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How we measure capital movements
Bottom-up or top-down?
Before we discuss the actual size and momentum of global capital movements, we need to take a short detour and explain how we go about measuring capital flows at the macro level.
Reading market analysis in the financial press, you can find any number of different indicators thrown around here, and one of the most common approaches is to look at market-specific data points: monthly flows into emerging equity or bond funds, new securities issuance data, options market positioning metrics, cross-border banking statistics, etc. All of these are very useful, of course, and in the sections below we will cite some of them in our analysis.
However, from a macro point of view these “bottom-up” sources present two problems. The first is that we don’t have anything close to full information within specific asset classes; figures for equity markets and certain types of banking transactions are arguably a bit more comprehensive, but trying to gauge the magnitude of movements in and out of EM local rates or currency markets is still a matter of guesswork rather than science.
Second, and more important, even if we had better market information for standard asset classes there’s more to capital movements than just equity and bond flows; formally reported balance of payments transactions in many EM countries are at least matched (and in some cases dominated) by informal flows of “hot money” and unrecorded or disguised transactions.
And when we do macro analysis on currency pressures, official intervention and monetary trends, we really do need an all-inclusive measure that captures the full spectrum of flows.
Our best broad measure
As a result, at the macro level we use a very basic – but generally more reliable – balance of payments approach to capital movements.
Most EM countries provide three pieces of relatively “hard” data: (i) the current account balance, including goods and services trade as well as identified cross-border income flows, (ii) direct investment flows, i.e., new investment projects or acquisitions of large stakes in existing companies, and (iii) the net change in official central bank FX reserves. The quality of these figures is not perfect, of course – but at very least they are generally the easiest concepts to measure in any economy.
And once we know these three, the difference between them (reserve accumulation less the current account less net FDI) is a very good measure of implied net portfolio capital movements, capturing all formal transactions plus the balance on unrecorded “errors and omissions”.
This is not a perfect gauge – and in fact, it is almost useless in the case of Middle East Gulf states and a few other commodity exporters that don’t actually accumulate surpluses in central banks, preferring to route net claims on the rest of the world through sovereign and quasi-sovereign wealth funds that are “hidden” within the capital account of the balance of payments.
As a result we are forced to exclude the Middle East from our EM-wide aggregates in order to avoid distortions in the estimated magnitude of implied capital flows. Nonetheless, for the rest of the emerging world we focus on this construct as our single best indicator of net flows in the analysis that follows.
What the numbers show
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What do the numbers look like? We provide a much more comprehensive picture in the next section – but here’s a simple representative snapshot of the figures for the aggregate EM world (excluding the Middle East) on a 12-month cumulative basis, going back to 1990:
Chart 17. How we estimate capital flows
Share of EM GDP, cumulative 12m, (excluding Middle East) 6% Total FX reserve accumulation 5% Current account balance Net FDI balance 4% Implied non-FDI capital flows
3%
2%
1%
0%
-1%
-2%
-3%
-4% 1990 1995 2000 2005 2010
Source: Haver, CEIC, IMF, World Bank, UBS estimates
The green bars in the chart show the level of total FX reserve accumulation (or the “overall balance of payments”) as a share of GDP, while the light-colored lines indicate the current account balance and net FDI inflows; taking the bars and subtracting those two lines, we are left with estimated net portfolio capital movements (the dark blue line).
Net vs. gross
One final note before we go on: The estimates above suggest net EM portfolio inflows of just over 1.5% of GDP in the 12 months to end-September 2010, which corresponds to a level of US$300 billion. If we add in reported FDI flows, we arrive at net total capital of some US$500 billion. A number of investors have asked how we reconcile these estimates with those of the Institute for International Finance (IIF) and other agencies, which suggest private capital flows of US$800 billion to US$1 trillion this year.
The short answer is that the latter numbers are closer to gross in nature; they include identified inflows and repatriation of funds by foreign investors, but do not include implied outflows by EM households and firms (which in fact make up a significant portion of the overall volatility of net flows).
Both approaches are useful in their own right, of course, and we will provide some data on foreign holdings of specific EM financial markets further below – however, from a macro perspective what matters for the “big” arguments about capital controls, inflation pressures and currency movements is the all-in net amount, and this is the main focus of our report.
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How big are net flows into EM?
EM-wide flows
So, let’s look once again at the line for 12-month cumulative portfolio capital flows, as shown in Chart 18 below. According to our estimates, net EM flows over the past four quarters are nearly as high as they’ve ever been as a share of GDP, at a level of roughly 1.5%.
Chart 18. 12-month flows (quarterly) since 1990 Chart 19. Monthly flows since 2000
Non-FDI capital flow s, cumulative 12m (% of GDP) Non-FDI capital flow s, 3mma, (% of GDP)
3% 4%
3% 2% 2%
1% 1%
0% 0% -1% -1% -2%
-2% -3% -4% -3% -5%
-4% -6% 1990 1995 2000 2005 2010 03 04 05 06 07 08 09 10
Source: CEIC, Haver, IMF, UBS estimates Source: CEIC, Haver, IMF, UBS estimates
Does this mean that emerging markets are now being absolutely swamped by overwhelming and unsustainable inflows?
Not really, in our view. And we say this for two reasons.
First, if we were to draw a two-year line instead of the 12-month version, we would find that cumulative flows since mid-2008 are still negative. I.e., EM has seen very strong capital reflows since the middle of last year, but most of this presumably represents money returning to markets rather than a massive flood of “new” funds; we’ll have more to say about this point further below.
And second, when we look at estimated flows on a monthly rather than cumulative basis, the biggest period of influx was actually the second half of 2009 and the beginning of 2010; capital movements have also been positive over the past couple of quarters, but not nearly as strong on average.
Flows by region
How do flows look by region? The cumulative and monthly pattern for Asia, emerging Europe and Latin America is shown in Charts 20 and 21. As we show below, it’s difficult to form a regional view in light of very wide country-level disparities, but the general impression is that Asia and emerging Europe are not experiencing inordinately large inflows today relative to pre-crisis movements over the past decade – and that the one region that is arguably seeing movements somewhat beyond recent historical experience is Latin America.
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Chart 20. 12-month flows by region Chart 21. Monthly flows since 2000 by region
Non-FDI capital flow s, cumulative 12m, (% of GDP) Non-FDI capital flow s, 3mma, (% of GDP) 6% 10% Asia Asia 8% Emerging Europe Emerging Europe 4% Latin America 6% Latin America
4% 2% 2%
0% 0%
-2% -2% -4%
-6% -4% -8%
-6% -10% 1990 1995 2000 2005 2010 03 04 05 06 07 08 09 10
Source: CEIC, Haver, IMF, UBS estimates Source: CEIC, Haver, IMF, UBS estimates
Flows by country
But again, the real action is occurring at the country level. As you can see in the two charts below, whether we measure over the past three months or the past 12 months there is a recognizable “high-inflows” group of economies – a group cutting well across regional boundaries, incidentally – that has seen very strong capital movements relative to peers, as defined by net inflows of 5% of GDP or above.
Chart 22. Net flows, past 12 months Chart 23. Net flows, most recent quarter
Non-FDI capital flows, past 12 months (% of GDP) Non-FDI capital flows, Q3 2010 (% of GDP) 20% 20%
15% The high-inflows group 15% The high-inflows group
10% 10%
5% 5%
0% 0%
-5% -5%
-10% -10%
-15% -15%
-20% -20% India Peru India Chile Peru Israel Chile Brazil Egypt Israel China Latvia Korea Brazil Egypt Latvia China Korea Slovak Czech Turkey Mexico Poland Czech Slovak Russia Turkey Taiwan Poland Mexico Russia Ukraine Estonia Taiwan S Africa Ukraine Estonia Vietnam Bulgaria S Africa Hungary Thailand Vietnam Bulgaria Malaysia Hungary Thailand Lithuania Malaysia Romania Lithuania Argentina Romania Colombia Indonesia Argentina Colombia Philippine Indonesia Singapore HongKong Singapore Philippines HongKong Source: CEIC, Haver, IMF, UBS estimates Source: CEIC, Haver, IMF, UBS estimates
Perhaps unsurprisingly, these are relatively concentrated towards what we might call “safer high-yielders”, i.e., countries with attractive onshore fixed-income yield prospects and good macro balance sheets: Turkey, Brazil, India, Poland, South Africa and to some extent Peru. The group also includes a few more idiosyncratic cases such as Ukraine (high nominal yields arguably combined with some rerating of tail risks), Thailand (lower local interest rates, but one of the best currency performers in the EM world) and Hong Kong (an early recipient of specific liquidity flows, discussed in further detail below).
On the other end of the spectrum we have high-saving, low-yield countries (Singapore, Malaysia, more recently Hong Kong, as well as Chile and Israel) as well as the more problematic balance-sheet cases (Balkans, Baltics, Hungary, Vietnam and Argentina). And somewhere in the middle are Korea, Russia, China, Philippines, Egypt, Indonesia, Mexico and Columbia, with positive but much more moderate net flows.
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The search for yield
I.e., if we could make four preliminary conclusions from the above charts, they would have to be that (i) total flows to EM are strong but less than overwhelming, (ii) specific EM countries are seeing a disproportionate amount of activity, (iii) most of the money coming today is in search of “safe” yield, and (iii) this search is strongly skewed toward local debt markets.
Which brings us to the next section on market trends.
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Where is the money going? (And do we see bubbles?)
Watch the debt side for now
In Chart 24 below we provide a very rough breakdown of implied (cumulative 12-month) portfolio capital flows by broad category, including (i) net equity flows, and (ii) “other” credit, banking and currency- related movements. As discussed above, we have some reasonably good data sources for the equity side and we use these to build a proxy series for overall equity flows; unfortunately it’s very difficult to do the same for the debt and currency side, and as a result the green bars in the chart are defined as a residual. 1
Chart 24. Where the action is
Non-FDI capital flows, cumulative 12m (% GDP) 3%
Other flows 2% Equity flows
1%
0%
-1%
-2%
-3%
-4% 1990 1995 2000 2005 2010
Source: EPFR, Haver, CEIC, IMF, UBS estimates
Despite the ad-hoc nature of these estimates, in our view the overall conclusion could not be more clear: net equity flows can be moderately volatile, but at a macro level the “real” action comes from the debt side of the market. The blue (equity) bars in the chart range from around zero to 0.5% of GDP ... while the green bars are simply all over the map, swinging from peaks of nearly 2% of GDP all the way down to - 3% of GDP. And debt- and currency-related flows were responsible for the lion’s share of volatility in the past three years as well.
This should come as no surprise. Equity purchases in EM tend to be cash in nature, given the relatively unlevered nature of the underlying foreign investor base as well as the lack of derivative structures in most markets. By contrast, debt and currency investors by their very nature tend to use much greater gearing in establishing positions, which can lead to much greater swings in cross-border volumes in both directions when markets move.
I.e., from a top-down perspective, it’s really debt and currency flows you want to watch. And as we will argue, positioning in these markets today is “strong, but not obviously overdone” – so while we clearly see two-way risks building up, we’re not talking about unsustainable market bubbles in the classical sense of the word.
1 Specifically, from 2000 onwards we use EPFR data on net flows to EM funds and ETFs, augmented by a fixed multiple to adjust for non-dedicated global flows; prior to 2000 we use total net flow data for Asian markets, similarly adjusted to add a proxy for flows to other regions. This is far from rigorous, of course – but cross-checking these numbers against reported foreign holdings in key markets seems to yield a reasonable correlation.
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Equities
We start with the equity market, where the relevant valuation and positioning indicators are most relaxed. Chart 25 below shows our two best measures of foreign investor positioning: (i) implied cumulative foreign holdings as a share of market capitalization using EPFR data for net EM-dedicated mutual fund and ETF flows, and (ii) average foreign-held shares directly reported by selected national exchanges.2 Neither of these measures is perfect, of course; the former does not include flows from global funds and other non-dedicated investors, and the latter is only for a sample of EM countries.
Luckily, however, they both show almost exactly the same trend: Foreign investors took positions down mildly in late 2007 and 2008, then rebuilt them in 2009 – but as of mid-2010, neither indicator suggests that foreign holdings have risen beyond earlier peaks (and in fact our best estimate is that foreign shares are still slightly below pre-crisis averages).
Chart 25. No aggressive positioning here Chart 26. Still lagging earnings?
% of free-float market cap % of free-float market cap Index level (1995-2005 avg=100) 20% 40% 350
300 35% 16% Implied US dollar earnings 250 30% MSCI EM index 12% 200 25% 150 8% 20% EM-dedicated/ETFs (LHS) 100
4% Reported total holdings (selected countries) 15% 50
0 0% 10% 1995 2000 2005 2010 02 03 04 05 06 07 08 09 10
Source: EPFR, CEIC, national exchanges, UBS estimates Source: MSCI, UBS estimates
The same is true when we plot actual MSCI EM index performance against the path of implied earnings (as defined earlier on). As of this writing, the overall index has yet to reach earlier 2007 peaks (Chart 26), whereas underlying earnings in the emerging world are already moving beyond historical levels and by our estimates should exceed full-year 2007 levels by 15% or more by end-2010. In other words, there’s no sense that recent equity gains have been excessive compared to relevant macro metrics.
Finally, looking at relative valuations on the MSCI EM index compared to the developed MSCI World counterpart in Chart 27 below, it’s clear that the emerging discount has been narrowing in recent quarters, but markets are still a good distance from the outright premium that was being priced in 2007 (and the latest work by EM equity strategist Nicholas Smithie suggests that a small premium is warranted given the differences in the fundamental outlook, see What is GEM Worth?, UBS Q-Series, 29 July 2010).
As a result, both Nicholas and our global asset allocation team continue to maintain an overweight recommendation in the EM equity space.
2 The reporting countries are Brazil, Czech Republic, Hungary, India, Korea, Malaysia, Poland, Taiwan and Turkey.
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Chart 27. Relative premium/discount on EM equities
EM premium/discount (MSCI EM vs. MSCI World) (%) 30% Relative trailing P/E 20% Relative forward P/E
10%
0%
-10%
-20%
-30%
-40%
-50%
-60% 90 92 94 96 98 00 02 04 06 08 10
Source: MSCI, UBS estimates
External debt
It may seem a bit strange to include external sovereign debt indicators in this section, since flows into dollar- and other FX-denominated EM debt markets don’t really show up as a capital inflow into the relevant economies, i.e., they are not part of the capital flows metrics we defined above. However, these markets are clearly part of the “global liquidity” story more broadly defined, and as a result it’s helpful to look at indicators here.
When we do we tend to see markets that are fairly tightly priced, but also generally in line with underlying fundamentals. As shown in Chart 28, EMBI and CDS spreads have fallen considerably from crisis-era peaks, but are still trading well above 2006-07 levels. And when EM FX/fixed income strategist Bhanu Baweja and global asset allocation strategist Sunil Kapadia look at EM dollar sovereign pricing they generally point to the much stronger fiscal debt and deficit dynamics in the emerging universe (see for example Chart 29, which shows the recent sharp widening of developed central government deficits compared to those in EM).
Chart 28. EMBI and CDS spreads Chart 29. EM vs. developed – fiscal balance
Basis points Central government balance (% GDP) 1000 4% EMBI 900 CDS 2% CDS excluding high 800 0% 700
600 -2% 500 -4% 400 EM 300 -6% Developed 200 -8% 100
0 -10% 2007 2008 2009 2010 01 02 03 04 05 06 07 08 09 10
Source: Bloomberg, UBS estimates Source: CEIC, Haver, IMF, UBS estimates
As a result, while they have a tactical underweight in EM hard-currency sovereign debt they also stress the medium-term value in the sector (see Adding Emerging Debt, UBS Weekly Weight Watcher, 24 September 2010).
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Local-currency debt
This brings us to the local-currency side of the market, which is perhaps the most interesting and debated asset class in EM today. Start with Chart 30, which shows the average foreign-held share of local government debt markets as reported by a sample of EM countries, compared to the reported foreign share of equity markets discussed above. 3
Chart 30. Local debt positioning
Foreign share of local market cap (selected countries)
40% Equity (LHS) Local-currency debt (RHS) 35%
30%
25%
20%
15%
10%
5%
0% 02 03 04 05 06 07 08 09 10
Source: CEIC, Haver, National exchanges, UBS estimates
As you can see, the foreign-held share of local-currency sovereign debt rose sharply over the past six years, and has continued to jump past earlier pre-crisis peaks during 2010 – with both of these trends in visible contrast to equity markets. On the other hand, average foreign debt holdings are still a good bit below average reported equity shares.
Add to this the fact that average EM domestic interest rates are almost certainly below medium-term trend (as we will discuss below) and should generally rise over the next year or two as inflation heats up, and you can see the propensity for debate: Are local debt markets overinvested? Underinvested? Overpriced?
When Bhanu looks at the issue his response has been that – for the moment, at least – concerns over inflation and potentially rising yields are generally outweighed by the trend development of local EM debt as a globally-invested asset class, together with the more favorable near-term fiscal outlook; as a result, he and Sunil actually have a tactical overweight in local-currency fixed income assets (see the above-cited report as well as the latest issue of the Emerging Markets Navigator, Engineering Inflation, But Where?, 22 October 2010).
Currency positioning
A similar debate is being carried out on the EM currency front. On the one hand, as we will discuss in the next section, emerging currencies do not appear remotely overvalued on the whole, either from a real exchange rate or balance of payments perspective; if anything, the opposite is true. And even on an individual basis it’s very difficult to find currencies that are obviously structurally challenged on the downside (most of the argument surrounds a handful of EM commodity currencies, as well as highly idiosyncratic cases such as Argentina and Venezuela).
3 The reporting countries are Indonesia, Korea, Malaysia, Mexico, Poland, Thailand and Turkey.
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On the other hand, however, the one good indirect indicator of positioning we have – i.e., implied 3-month volatility for a sample of traded EM currencies – shows that volatility levels have essentially fallen all the way back down to pre-crisis levels, a trend which seems incompatible in the near term with our concerns about potential global liquidity risks (Chart 31).4
Chart 31. Implied EM FX volatility
Implied 3-month FX volatilty (selected EM currencies) 45
40
35
30
25
20
15
10
5
0 2007 2008 2009 2010
Source: Bloomberg UBS estimates
In light of this situation, and despite a generally favorable overall macro view on fundamental valuations, FX is the one asset class where Bhanu has recommended the most caution in the near term.
What about property?
As a quick final note, what about property? We mention this because of a general investor perception that (i) property markets around the emerging world are “heating up”, and (ii) this is a direct result of global liquidity and global interest rate policies.
As we noted in the summary, property markets tend to be a late-cycle story in the EM universe, driven more by domestic demand and leverage conditions than by global inflows. And sure enough, when we look at the behavior of local property markets relative to incomes in Asia (where we have by far the best time series data on economy-wide property trends), we don’t see any evidence of a sudden surge in prices for most markets (Chart 32 below).
The main exceptions are Hong Kong, Taiwan and Singapore – and Hong Kong and Singapore in particular are hardly representative of emerging markets as a whole; they are essentially fully open city-states where foreign capital flows can and do play a much bigger role in marginal pricing. Nor, as we will argue below, should we make the common mistake of looking at Hong Kong as the “canary in the coal mine” for the EM world at large; the Hong Kong economy has a number of special characteristics that make it relatively unique by emerging standards.
4 The chart shows average implied 3-month volatility for EURHUF, EURPLN, USDBRL, USDIDR, USDINR, USDMXN, USDTRY, USDZAR and USDKRW.
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Chart 32. Asian property markets
Property price/income ratio (index 2000=100) 200 Hong Kong Singapore 180 Korea Taiwan Thailand Malays ia 160 China
140
120
100
80
60
40
20
0 1995 2000 2005 2010
Source: CEIC, UBS estimates
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Is the EM macro model at risk?
Now to the heart of the matter
Now, after the long lead-in sections above, we come to the very heart of our report: the impact of global capital flows on macro policies and macro stability. And here we will present two main arguments: First, despite the visible pick-up in inflows over the past 12 months, there is no clear threat to exchange rate pegs or domestic monetary policy in the near term, i.e., EM countries are not being “overwhelmed” by flows at the macro level. And second, the real threat to emerging macro stability comes further on down the road, as a combination of structurally loose interest rates policies and potential asset price bubbles could lead to higher inflationary pressures and rising balance sheet leverage over the coming few years.
What is the “EM model”?
We begin with a very basic point: Most EM countries manage their currencies, and manage them heavily. Indeed, the emerging landscape is littered with a combination of outright pegs, quasi-pegs and strongly intervened “range-bound” baskets; this is not true absolutely everywhere, but the list of truly floating EM currencies without significant intervention is a very, very short one.
You can see this point in the two charts below. Chart 33 shows average monthly official FX intervention, in absolute annualized terms, as a share of GDP between 2001 and 2010. As it turns out, there are only a three or four major countries where average intervention was less than, say, 2% of GDP per year (these are South Africa, Colombia, Mexico and Indonesia). Nearly half of emerging majors have outright pegs or basket pegs, spending anywhere from 5% to 10% of GDP on foreign exchange intervention, and even those remaining countries that investors often think of as “floating” – Turkey, Chile, Korea, India, Poland, etc. – intervene regularly in relatively heavy amounts (3% to 4% of GDP). By contrast, the average for G10 countries would be nearly zero.
Chart 33. Does anyone really float? Chart 34. Peg then, peg now
Absolute monthly FX intervention (% of GDP, annualized) EM NEER against G3 currencies (Index 2007=100) 20% 110 Weighted average 15% Pegs and quasi-pegs Average The "quasi-floaters" 105 10% Peg now 5% 100
0% 95 -5% Peg t h en -10% 90 Heavily managed -15% 85 -20% India Peru
Chile 80 Israel Brazil Egypt Latvia China Korea Slovak Czech Turkey Poland Mexico Russia Taiwan Estonia Ukraine S Africa Bulgaria Vietnam Hungary
Thailand 2005 2006 2007 2008 2009 2010 Malaysia Lithuania Romania HongKon Argentina Philippine Colombia Indonesia Singapore Source: CEIC, Haver, IMF, UBS estimates Source: Bloomberg, UBS estimates
As a result, when we look at the EM world from the top-down, the aggregate currency position looks almost exactly like a peg, with perfectly flat nominal effective performance against the G3 basket leading up to the 2008 crisis, and following a brief but intense depreciation, virtually flat performance against the G3 once again from 2009 onwards (Chart 34).
In short, the first main pillar of the EM macro “model” involves highly managed currencies and a good deal of intervention to keep them in place.
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The impossible trinity?
And this leads directly to a discussion of what we call the “impossible trinity”. According to economic theory, a small, perfectly open economy cannot maintain (i) a fixed exchange rate, (ii) free and open external capital flows, and (ii) independent monetary policy all at the same time. If a shock hits the system, one of these three things has to give.
Putting this in the context of near-zero developed interest rates and the current wave of global capital inflows, many investors are concerned that the traditional EM model is coming under increasingly severe stress, and that countries will be forced to either let currencies soar upwards, face massive domestic inflationary pressures ... or shut the doors by imposing onerous capital controls at the macro level.
Not so impossible
Perhaps the single most important finding of this report, however, is that these fears are highly overblown. The reason is that as large as global capital flows may appear today, on an EM-wide basis they’re simply not big enough to have a dramatic near-term impact on macro outcomes.
Of course we see potential for more moderate stresses in the system; some countries may have to adjust domestic sterilization policies at the margin to accommodate greater flows; some will allow stronger currencies at the margin and, crucially, some will continue to impose tactical capital controls to fight peak speculative flows.
In the broadest sense, however, we expect EM countries to look, well, pretty much the same as they do now, with continued strong intervention, relative currency stability, gradually rising inflation and mostly open financial markets over the next couple of years. In other words, we don’t see global flows as a “game changer” that will force wrenching adjustments in the way emerging markets work.
Again, in our view the real impact of higher global flows will come over the medium term, as higher structural inflation and potentially overpriced asset markets lead to a worsening of balance sheets down the road. But we do not see this as a dominant theme for 2011.
One chart that says it all
One chart should suffice to show exactly what we mean. The blue line in Chart 35 once again shows net portfolio capital flows into the EM world as a whole, as defined earlier above.
However, from a pure macro perspective it’s not the blue line that matters for the sustainability of currency or monetary policy – rather, it’s the green bars, which indicate total FX intervention (defined as the overall balance of payments less interest accrued on outstanding FX reserves) as a share of GDP. This is a measure of the total dollar supply “hitting” EM central banks, including portfolio capital, FDI inflows and current account surpluses.
And what the green bars are telling us is that while EM currency intervention pressures have returned over the past 12 months, they are still a good bit lower than the 2005-07 peak. In other words, far from facing an unsustainable wall of cash, most central banks are actually somewhat less stressed today than they were three years ago, due to a slowdown in other dollar inflows (less net foreign direct investment, lower trade and current account surpluses in the aggregate).
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Chart 35. Capital flows vs. overall FX pressures
Share of EM GDP, cumulative 12m, (excluding Middle East) 6%
5% Total FX intervention Implied non-FDI capital flows 4%
3%
2%
1%
0%
-1%
-2%
-3%
-4% 1990 1995 2000 2005 2010
Source: CEIC, Haver, IMF, UBS estimates
This true across broad regions as well; Chart 36 shows total FX intervention for Asia, emerging Europe and Latin America, and all three groups are show less pressure on central banks today than during the 2005-07 period.
Chart 36. Intervention pressures by region Chart 37. Balances for “high-yielders”
FX intervention, cumulative 12m, (% of GDP) Share of EM GDP, cumulative 12m 10% 6% Asia 5% Total FX intervention 8% Emerging Europe Implied non-FDI capital flows Latin America 4% 6% 3% 4% 2%
2% 1%
0% 0% -1% -2% -2% -4% -3%
-6% -4% 1990 1995 2000 2005 2010 1990 1995 2000 2005 2010
Source: CEIC, Haver, IMF, UBS estimates Source: CEIC, Haver, IMF, UBS estimates
And, crucially, the finding holds for “high-yield” economies in Chart 3. In this chart we took every economy with average interest rates above 5% per annum and aggregated together; of course portfolio capital inflows have been particularly strong here, nearly 3% of GDP this year – but the overall intervention balance for these countries is only half of the peak 2007 level, which means that central banks are still under less immediate strain. 5
No monetary pass-through, no inflation
This, in turn, explains why there has been (i) no explosion of high-powered “base” or broad money aggregates, and (ii) no strong pick-up in inflation in the EM world. Chart 38 below shows the aggregate y/y pace of base money growth for emerging countries; as you can see, there has been a very mild increase
5 The high-yield group is Argentina, Brazil, Colombia, Egypt, Hungary, India, Indonesia, Mexico, Philippines, Poland, Romania, Russia, South Africa, Turkey, Urkaine, Venezuela and Vietnam.
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since the 2009 trough, but on the whole base money is still expanding at a pace well below the 10-year average. Private credit activity has started to bounce more visibly, but is hardly aggressive on a 12-month basis ... and broad money M2 growth is still falling as we write (Chart 39).
Chart 38. Base money growth Chart 39. Broad money and credit growth
Base money growth (3mma, % y/y) Grow th rate (% y/y) 30% 30% Broad money Private credit 25% 25%
20% 20%
15% 15% `
10% 10%
5% 5%
0% 0% 2003 2004 2005 2006 2007 2008 2009 2010 2003 2004 2005 2006 2007 2008 2009 2010
Source: CEIC, Haver, IMF, UBS estimates Source: CEIC, Haver, IMF, UBS estimates
As a result, despite the recent jump in food and grain prices, the pace of headline inflation is still either flat or declining slightly in most countries we cover, and below pre-crisis averages as well (Chart 40).
Chart 40. CPI inflation in the emerging world
Inflation rate (% y/y) 14%
12% Average Weighted average 10% Median Overall
8%
6%
4%
2%
0% 2003 2004 2005 2006 2007 2008 2009 2010
Source: CEIC, Haver, IMF, UBS estimates
In short, at the aggregate level it’s difficult to find any evidence of globally-driven monetary or inflation pressures hitting the emerging universe. In fact, just eyeballing Chart 35 above, we suspect that total portfolio flows would probably have to double or even triple in size from current levels before they became a truly urgent macro issue for emerging markets as a whole.
The model goes on
And as a result, we see no imminent economic threat to the “EM model” as it currently stands, i.e., keeping currencies close to the dollar and the euro through strong FX intervention.
The risk countries
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This statement doesn’t hold up for every individual country, of course, and we need to take a closer look at the current “risk cases”. In the two charts below we highlight those economies with a combination of (i) all-in FX intervention pressures of 5% of GDP or more, and a significant positive contribution (say, 3% of GDP or above) from net portfolio flows, either for the past 12 months or over the most recent quarter.
Chart 41. The “risk cases” – 12-month basis Chart 42. The “risk cases” – 3-month basis
FX invervention, 12m cum, (% of GDP) FX invervention, 3mma, (% of GDP) 20% 20% PERU HONG 15% 15% THAI TA IW 10% THA I 10% UKRA LATV UKRA CZEC POLA LITH PERU POL A 5% 5% BRAZ
0% 0%
-5% -5%
-10% -10% -20% -10% 0% 10% 20% -20% -10% 0% 10% 20% Non-FDI capital flows, 12m cum (% of GDP) Non-FDI capital flows, 3mma, (% of GDP)
Source: CEIC, Haver, IMF, UBS estimates Source: CEIC, Haver, IMF, UBS estimates
As shown, there are clearly a handful of countries where recent total intervention pressures have been much higher than average, but the interesting thing here is that they don’t completely fit in with the earlier list of high-yield inflows countries.
On a 12-month basis the three economies that stand out for the most serious overall conditions, in terms of a combination of strong intervention and strong capital flows, are Hong Kong, Taiwan and Thailand (Chart 41) – not exactly the first destinations that come to mind when thinking about the global search for yield (we look at the special case of Hong Kong below).
And over the past three months the most dramatic aggregate pressures have been recorded in Peru, Thailand and Ukraine, again, not necessarily the first countries most investors would think when reading about “currency wars” in the financial press. Brazil (which has been very much in the press) did make it into the top group as well – but somewhat behind Latvia, Lithuania, the Czech Republic and Poland in the macro scheme of things.
Can we say that these countries, at least, are under more serious macro risk? Well, Brazil and Peru do have buoyant recent growth numbers, a more advanced credit cycle, very strong currencies and some signs of accelerating inflation. The Thai economy is arguably weaker, but inflation has been visible and the baht has been one of the best performers over the crisis period; it should come as no surprise that Brazil and Thailand were among the first to impose new targeted capital controls this year (we’ll have more to say about capital controls further below).
But the remaining Central and Eastern European group have weaker credit recoveries, if there is recovery at all, currencies that can hardly be called overvalued and mostly non-threatening inflation trends; in this environment, capital and monetary inflows would arguably be welcome for a good while to come. Nor can we really say with any certainty that these countries will continue to receive inflows in six months or nine months’ time (and in some cases we would be very surprised if inflows proved sustainable).
In other words, while it’s certainly worth keeping a close eye on this group – and in our view the Latin American economies in particular is where the battle over global capital might first come to a head – the general picture is still not one of a fragile equilibrium being threatened by a “wall of cash”. And in many cases we may wake up to find that short-term capital flows can be very volatile and unpredictable.
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Not the canary – the special case of Hong Kong
At this point we need to add a few particular notes about Hong Kong. As a reminder, no sooner had the global crisis broken out, and no sooner had the Fed begun to expand its balance sheet, than the Hong Kong economy saw a sudden, massive rush of external capital coming in, pushing it far beyond the EM average in terms of total intervention pressures in 2009 (see Chart 41 above). Since Hong Kong runs a currency board, these funds immediately made their way into the domestic money stock, almost immediately started to inflate domestic property prices, and the broad credit cycle began to heat up sharply soon afterwards.
With this experience in mind, many investors argue that Hong Kong is the “canary in the coal mine” for the rest of the emerging universe, and that many other economies could soon also see overwhelming capital movements that very quickly destabilize domestic money, credit and asset market conditions.
In our view, however, this is simply not the case. There are many fixed pegs – and more than a few currency-board and similar “hard” peg arrangements – in the emerging world, but Hong Kong was very unique in terms of the inflows it attracted.
You can see this in Chart 43, which shows the cumulative expansion in base money since the onset of the crisis in all of the pegged EM countries. In most cases total inflows were actually below the emerging average, and a number of countries actually saw net outflows in the past two years. Only Hong Kong and (interestingly) Qatar recorded anything close to a doubling of the base money stock in the same period.
I.e., it’s clearly not the case that global liquidity is pushing money into EM markets indiscriminately and that small, pegged countries are the first to suffer.
Chart 43. Not your normal EM peg
Cumulative base money expansion since end-2008 (%) 100%
This is not a "normal" EM peg 80%
60%
40% (Average for all EM countries) 20%
0%
-20% Haiti UAE Qatar Saudi Latvia Oman Kuwait Jordan Bosnia Estonia Bahrain Bulgaria Ecuador Panama Lebanon Maldives Lithuania El Salvad El Macedoni Honduras Bahamas Singapore HongKong Venezuela Source: CEIC, Haver, IMF, UBS estimates
So what made Hong Kong special? After all, it is not remotely a “high-yielder” economy; in fact, it is one of the very few places we cover where interest rates are more or less exactly as low as in the US, hardly an attractive place for money seeking yield.
In our view there were two additional elements here that contributed largely to Hong Kong’s dizzying inflows in the first half of 2009. One is its proximity to China, which as many readers will recall embarked on an unprecedented round of monetary stimulus and credit expansion during precisely that period; these funds fueled a strong rebound in mainland property prices, and a large amount of anecdotal evidence indicates that these funds played a key role in the initial jump in Hong Kong property assets as well.
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And second, like Japan, Hong Kong was actually a substantial net capital exporter throughout the 2003-08 boom – and in this light it is not surprising that, like Japan, Hong Kong saw a flood of capital repatriation when the global crisis set in and the pre-crisis “carry trade” began to unwind.
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Sterilization
A bit of math
In the previous section we argued that capital inflows are not an imminent threat to the emerging macro model. Now we would like to turn to a more detailed discussion on the one of the key elements of that model – monetary sterilization – and tie this in to a few thoughts on interest rates and inflationary pressures over the medium term.
What is sterilization?
We need to begin with a short discussion of what exactly we mean by sterilization. The informed reader who has been through the logic before should feel free to skip this section, but in our experience sterilization remains one of the least-understood topics in emerging economics and we can hardly go forward without ensuring that the everyone is on the same page.
In previous publications we often provided a full set of charts and graphs, but we will restrict ourselves here to a verbal explanation and offer further references upon request. At the simplest level the mechanics are as follows: Imagine that a foreign investor wants to buy a local-currency asset in Poland (we could also equivalently use the example of an Polish export firm selling its foreign exchange proceeds, but since this report focuses on global capital flows we will stick to the story at hand). How does the transaction proceed?
The investor takes dollars and buys zloty from a local Polish commercial bank, then uses the zloty to buy assets; and from the investor’s point of view the transaction is finished. However, assuming that commercial banks have no use for extra dollars on their balance sheets (and this in itself entails a very long discussion), the bank ends up selling the dollars to the Polish central bank for zloty.
In return for buying the dollars, the central bank credits the commercial bank’s reserve account with new zloty – or, in other words, it creates new money. And indeed, every time central banks intervene on a net basis to buy foreign exchange, they automatically create new domestic currency in the form of new base money. This appears as a new liability of the central bank (as an offset to the increase in FX reserves), and an increase in commercial banks’ holdings of excess reserves on the asset side of their balance sheet.
So far, so good, and if the central bank does nothing else, the zloty base money stock has automatically increased in line with the dollar inflow. But suppose the authorities do not actually want base money to increase, either because they are concerned about fueling inflation or because real activity is already too strong?
Two options
In this case they need to take the money back – or, in other words, to “sterilize” it. How does the central bank do this? There are essentially two options here.
The first is to convince commercial banks to give the money back to the central bank, usually in exchange for an interest-bearing asset. This could come from existing central bank holdings of government securities, for example, or it could take the form of issuance of new term bills (either a direct liability of the central bank or issued by the government on its behalf). Either way, banks get an interest-bearing asset, the central bank gets its base money back, and all is good ....
Except, of course, that someone has to pay interest on the new securities now in the hands of banks, and this means either the central bank or the government. If the local-currency interest rate is lower than the corresponding interest rate on dollar reserve assets, then the authorities are still making money on the transaction (since they earn dollar interest on the reserves and pay local interest on the sterilization debt).
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However, if local interest rates are higher than global dollar rates, then sterilizing in this manner costs money – which means there is theoretically a limit to how much central banks can do without generating an upward cost spiral.
And this brings us to option two. In this case the central bank doesn’t borrow or buy the money back; instead, it just “freezes” it by increasing reserve requirements. The base money stock has still gone up, but by requiring banks to hold more reserves (i.e., base money) for a given level of deposits in the system, there is no longer a risk that the monetary increase will fuel greater lending activity or inflation. And from the central bank’s point of view the good news here is that it doesn’t cost money. Or at least not directly; some costs are incurred by the commercial banking system in terms of foregone revenues as a result of holding higher reserves.
Putting it all together
So why are we going through all this? What does it have to do with global capital flows?
The logic here is relatively straightforward: If EM countries are unwilling to move away from quasi- pegged or heavily managed currencies at the margin, then in a world of strong capital inflows they will have to continue to rely on FX intervention to keep currencies stable. And although emerging base money aggregates are still well-behaved today, many investors are concerned that with global interest rates at record low-levels EM central banks will eventually “run out of steam” in terms of the ability to sterilize those inflows as the cost dynamics increasingly move against them.
The good news here, however, is that there is no sign of severe stress on the broad EM sterilization front today, and no indication that this will change soon. Moreover, if inflows continue to accelerate strongly there is no reason that central banks could not shift to a greater reliance on administrative reserve requirements as a less costly means of sterilization for the near future. In other words, we don’t really see a “tipping point” in terms of quantitative monetary pressures on the horizon. (This is not all good news, of course; will discuss the negative implications of keeping domestic interest rates low in the next sections below).
How big is sterilization in practice?
Now for the details. Chart 44 shows the “standard” breakdown of total EM base money growth into its component parts: (i) net foreign assets, with is the amount coming in (or out) from FX intervention, and (ii) net domestic assets, the amount due to domestic operations. A negative value for the latter category (represented by the orange bars in the chart) means that central banks are sterilizing on a net basis.
Sure enough, looking at the orange bars, it’s clear that emerging central banks have been sterilizing in very significant amounts all through the 2003-08 global boom, and are still undertaking operations today.
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Chart 44. Sterilization in practice
Contribution to base money growth (pp) 60% NFA component 50% NDA component 40% Overall base money growth
30%
20%
10%
0%
-10%
-20%
-30% Sterilization -40% 01 02 03 04 05 06 07 08 09 10
Source: CEIC, Haver, IMF, UBS estimates
Which countries have been at the forefront here? In Chart 45 we show the implied cumulative sterilization “effort” by major EM economies since 2001 (defined as cumulative FX intervention less the cumulative increase in domestic base money).6 As you can see, most of the action has actually been in lower-yield, high-saving Asian economies such as Singapore, Taiwan, Malaysia and China; relatively few of the “high- yield” group have been actively involved (mostly Russia, Romania, Hungary, Brazil and India), and their total effort has been much lower.
Chart 45. Lots of sterilization going on Chart 46. But implied costs moderate
Implied cumulative sterilization effort (% of GDP) Implied sterilization cost (% of GDP) 80% 1.5%
60% 1.0%
40% 0.5% 20% 0.0% 0% -0.5% -20% -1.0% -40%
-60% -1.5%
-80% -2.0% India Peru Peru India Chile Chile Israel Israel Brazil China Egypt Korea China Brazil Egypt Korea Czech Czech Turkey Poland Russia Taiwan Turkey Taiwan Poland Russia Mexico Mexico Ukraine Ukraine S Africa Bulgaria S Africa Hungary Vietnam Thailand Bulgaria Vietnam Thailand Hungary Romania Malaysia Romania Malaysia Colombia Indonesia Argentina Colombia Argentina Indonesia Philippine Singapore Singapore Venezuela Venezuela Philippines Source: CEIC, Haver, IMF, UBS estimates Source: CEIC, Haver, IMF, UBS estimates
As a result, the “implied carry costs” of sterilization – as measured by cumulative effort multiplied by the current net gap between domestic interest rates and global yields in Chart 46 above – are extremely low, essentially zero or negative for most countries and really only positive for the handful of high-yield countries mentioned above. And even in these cases the actual costs are generally a good bit lower, since the calculations in the chart assume that all operations are carried out using interest-bearing securities, whereas most of these countries tend to rely on “costless” reserve requirement adjustments as well.
6 Please note that the calculations in Charts 45 through 48 were carried out at constant average exchange rates over the 2001-10 period as a whole; this clearly introduces a few distortions into the estimates for the most recent 12-month period, but in our view they are not inordinately large.
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Not getting worse
Nor do we see the situation worsening over time; indeed, quite the opposite. Looking back at Chart 44 above, although central banks have continued to sterilize inflows in the past 12 months, aggregate sterilization pressures are only around half of what they were in the pre-crisis period.
And despite common fears, it’s actually not true that aggregate sterilization cost dynamics have worsened today vis-à-vis the pre-crisis period. Of course global interest rates have fallen, as shown by the average developed 3-month/10-year line in Chart 47 – but so have short-term rates in the EM universe; as a result, the aggregate net sterilization cost “gap” is roughly the same today as it was during the peak sterilization period 2005-07.
The above points hold most individual major sterilization countries as well. On the horizontal axis in Chart 48 we plot the net increase in flow sterilization operations in the past 12 months compared to 2005-07 levels, as a share of GDP, and on the vertical axis we show the change in the net domestic-foreign interest “gap” over the same period. As you can see, only a few countries have seen an increase in total effort – and less than a handful of these actually have positive net carry costs.
Chart 47. No increase in overall rate “gap” Chart 48. And few countries increasing effort
Percent per annum Net change in cost "gap" vs. 2005-07 (pp) 10% 8% (difference) VENE 9% Average developed yield 6% EM short-term rate 8% EGY P 4% ARGE 7% VIET CHIN 6% 2% INDI MA LA ROMA PHIL POLA TA IW RUSS SOUT CZEC 5% UKRA HUNG SING 0% BULG BRAZ KORE PERU 4% MEXI THA I ISRA -2% COLO INDO 3% CHIL
2% -4% TURK 1% -6% 0% -10% -5% 0% 5% 10% 15% 03 04 05 06 07 08 09 10 Net change in sterilization effort vs. 2005-07 (% GDP) Source: CEIC, Haver, IMF, UBS estimates Source: CEIC, Haver, IMF, UBS estimates
Summing up
Just as in the previous section, our final conclusion here is that the common fears of rising EM-wide costs and patent unsustainability are considerably overstated. A few countries in particular could face stronger concerns if inflows continue to accelerate, but even in those cases we don’t see near-term “tipping points” and still see an ability to sterilize through administrative measures going forward.
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Near-term risks – flow reversals, capital controls and “currency wars”
What could go wrong?
In the final parts of the report we discuss the implications for economic life in the emerging world going forward. This section looks at some of the more common near-term investor concerns – “risk-off” events, capital controls, “currency wars” – and the next looks at more medium-term implications, including asset bubbles and higher inflation.
Risk off
So far the main focus of the report has been the implications of a low interest-rate, “risk-on” environment where capital flows in one direction – from developed markets to the emerging world. But what happens if we move to “risk-off”, and flows reverse? As we discussed earlier on, this could happen for a number of reasons, including renewed sharp global recession, sovereign default, or a renewed market focus on advanced-country inflation rather than easing.
In our view a sharp reversal of capital flows would clearly have negative near-term implications for all EM asset classes, including equities, dollar debt and local-currency rates.
However, the analysis above also suggests that the broader impact would be limited. As we argued, we don’t see outright bubble-like pricing in asset markets today, and at the aggregate level the bulk of inflows over the past 12 months have simply been a reversal of 2008-09 capital flight. This makes the current situation rather different from the 2007 pre-crisis peak, when market positioning had been built up unabated over a period of three to four years and had already spread to speculative bubbles across a wider range of assets like commodities and property.
This helps explain why we maintain a structural overweight on emerging assets in general and equities in particular, and why on the tactical side we choose to express negative views through relative-value and volatility plays rather than, say, shorting EM currencies or rates outright as a class (which would have been the right view in 2008).
Capital controls
The next topic is the risk of capital controls. And here we have two clear views: First, we are already seeing new measures in a few countries and in the current environment more are likely to follow; i.e., capital controls will probably be a fact of life in a world of strong global liquidity.
But second, given our findings above we don’t foresee anything like a “closing of doors” to foreign capital; controls will continued to be very targeted and selective, aimed at fighting periods of peak speculative flows rather than shutting down markets altogether. In other words, we see capital controls as a persistent tactical strategy theme rather than a big-picture macro issue.
Which markets are at risk? Bhanu Baweja wrote about this a few weeks ago in Is EM Heading Towards Capital Controls?, 29 September 2010), but you can get a sense of exposures from the charts in the previous section. First, which countries have seen the biggest recent inflows? At the top of the list we have Thailand, Peru, Ukraine, Poland, Czech, Brazil – and it should come as no surprise that Brazil and Thailand were among the first to impose transactions taxes on debt flows. Which countries have the largest overall intervention pressures? The names are similar here, but also include economies with the highest structural current account surpluses such as Singapore, Taiwan and Malaysia.
Which countries have the highest local-currency yields, and thus face the largest costs of sterilizing flows? Again, Brazil tops the list, and here we would add in Indonesia, India, Russia, Turkey, South Africa and Hungary, among others. Finally, which countries have the least willingness to see their currencies
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strengthen? Once again Brazil and Thailand, plus markets like Indonesia, South Africa and Colombia (and, we would add, the quasi-pegged large surplus economies like Malaysia and Taiwan). And it is precisely this final group that features most prominently in Bhanu’s analysis.
Currency wars?
The final issue concerns so-called “currency wars”, which, when applied to emerging markets, means the common fear that the EM world could face a global protectionist backlash against widespread currency intervention.
We wrote about this in greater detail in Who’s Next? (UBS Macro Keys, 13 October 2010), but our main conclusion is that the real potential battle is against perceived mercantilists, i.e., those countries that are intervening in a large-scale manner to protect sizeable structural current account surpluses – and not simply everyone who buys up dollars to offset speculative capital inflows.
And when we look around the emerging universe, we see exactly two blocs of countries that fit the “mercantilist” bills. The first is China, together with a few smaller neighboring Asian economies (Singapore, Malaysia and Taiwan) that also run chronic structural surpluses, and the second are the oil and fuel exporters – the Gulf states, Nigeria, Russia, etc. – where large current account surpluses are absorbed either by official central bank intervention or through separate sovereign wealth funds.
Indeed, when we add these two groups together they account for virtually all of the “surplus savings” that came out of EM in the past five years, and virtually all of the surpluses in the emerging world today. By contrast, most of the countries currently intervening to fight capital inflows – Brazil, Peru, Ukraine, Poland, Hungary, India, Turkey, etc. – run persistent structural current account and savings deficits.
So here’s the problem: Excluding China, the remaining Asian economies are pretty small, and they all have currencies that trade in correlation with the Chinese renminbi; in other words, they are essentially seen as an extension of the China issue and unlikely to attract much attention on an individual basis.
Nor do we seriously expect to see a protectionist backlash against major oil exporters. These are not manufacturing economies, which means that there is no perception whatsoever that they are taking jobs from US or European workers; we have yet to hear a diatribe from developed business lobbies about “unfair” exchange rate practices of the Saudi riyal or the Nigerian naira, and we would be extraordinarily surprised if we ever did.
The bottom line is that the EM “currency war” is really a US-China issue. This is true today, will almost certainly be true in twelve months’ time ... and most of the talk will probably still be about the US and China going into 2012 and beyond. In our view, there’s no one else waiting in the queue.
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Medium term concerns – asset bubbles, inflation
A risk template for the medium term
In this last section we now turn to the medium-term implications of the current global liquidity conditions. And here we have exactly two topics we want to discuss: one is asset bubbles, and the other is inflation.
Our summary risk scenario for the medium-term EM outlook would look roughly as follows: As we concluded above, despite the clear potential for continued and even accelerating global capital flows, nothing really changes in emerging markets in the immediate future; currencies remain stable, monetary aggregates stay well-behaved for the time being and inflation drifts upwards in line with strong growth. Some countries impose capital controls at the margin and tensions with China continue to simmer, but nothing threatens to unravel the basic macro model.
Over time, however, things start to look different, and particularly in the higher-growth regions of Asia and Latin America. Equity markets continue to rise and move from fair value to expensive and potentially even to outright unsustainable, inviting rising leverage along the way. Meanwhile, the strong global bid for yield keeps EM interest rates anchored at levels that are not necessarily compatible with high structural growth rates in some countries; domestic credit cycles not only recover but eventually move into heated territory, raising inflationary pressures (especially if global commodity prices are part of the liquidity story as well) and pushing up property markets in the process.
This, in turn, raises the exposure to an eventual “unwinding” of the liquidity trade. To put it in terms of the last time the world found itself in similar circumstances, if today’s conditions are analogous to 1990-91, the medium-term risk is that we move towards 1993, then 1994 ... and eventually even onwards to 1997. This would not be true everywhere in the EM world, of course, but there are certainly risks in the highest- growth and highest-yield parts of the region.
In any case, this is likely to be a long, multi-year process, and thus a theme we will have ample time to revisit along the way.
The case for asset bubbles
We wrote about the question of global liquidity and asset bubbles in much greater depth last year in The Next Emerging Bubble (EM Perspectives, 18 November 2009), and we won’t repeat the entire analysis here; instead, we would refer the interested reader to that report, especially since our conclusions are essentially unchanged.
But simply put, the argument on the asset side is as follows: If capital inflows are not overwhelming emerging macro balances, if they are not forcing dramatic currency adjustments, if countries are not running out of monetary policy options and if governments are not slamming doors shut through onerous capital controls ... then global capital will continue to run unimpeded to EM asset markets.
Three specific points here: First, this does not really depend on emerging central banks actually printing money. This is one of the most common investor misperceptions, i.e., that global capital flows in, central banks intervene, the domestic money supply expands, and only then does greater liquidity at home start to push up asset markets. However, as we discussed in the section on sterilization above, global portfolio capital goes directly to EM assets first, and central banks face the question of whether to sterilize the domestic liquidity implications in the aftermath. So even if central banks are actively managing the local money supply and the credit cycle, asset markets still feel the impact of foreign capital.
Second, when we talk about emerging asset markets and the potential for globally-driven bubbles, we are thinking first and foremost about equities. As we explained in the earlier report, local rates and debt
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markets are anchored by central bank policy and local liquidity conditions; global inflows can and do push down long-term yields in many economies, but despite the visible rise in foreign positioning over time there is generally a limit to how low yields can go. And as noted above, with the exception of the smallest markets such as Hong Kong and Singapore, direct foreign purchases also have a smaller impact on physical property markets; it isn’t until the domestic credit and leverage cycle really gets overheated that we normally see property markets “take off” into bubble territory (about which more in a moment).
Third, by contrast, EM equity markets (i) have unlimited upside in theory, and (ii) are heavily driven by foreign buying, and it should come as no surprise that equity markets are “ground zero” for global liquidity bubbles. In the earlier report we showed the dramatic example of the 1989-1994 period, which is essentially the last time we saw something similar to the global liquidity environment, with sharply falling interest rates, visible emerging economic outperformance and strong, sustained capital inflows.
Look for example at Chart 49, which shows the behavior of net portfolio capital flows in Asia and Latin America (which comprised most of the investible EM world back then). Capital inflows first began to appear in 1989-90, then showed up in earnest the following year ... and continued to rush in at record amounts for most of the next five years, reaching sustained peaks of 3% to 4% of GDP in many countries in these two regions. By contrast, looking at the chart, we are essentially still in year one of the same process today.
Chart 49. How it looked back then
Share of Asia/Latam GDP, cumulative 12m 6% Total FX intervention 5% Implied non-FDI capital flows 4%
3%
2%
1%
0%
-1%
-2%
-3%
-4% 1990 1995 2000 2005 2010
Source: CEIC, Haver, IMF, UBS estimates
How did these dramatic capital inflows affect Asian and Latin American economies? Just as we have argued above, there was no sudden, sharp currency adjustment; credit cycles were generally well-behaved in the initial years, particularly in Asia, and inflation actually fell in most economies from 1990-93. It wasn’t until 1994-97 that local Asian credit and property bubbles really got underway.
Instead, the main impact was on equity markets – and many equity markets simply skyrocketed. In an environment where US and European indices barely moved between the late 1980s and 1993, the average larger EM index gave returns of 300% or more over the same period, and as shown in Chart 50, smaller, less liquid emerging markets rose by anywhere from 600% to a stunning 1,600% in dollar terms.
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Chart 50. The bubble then ... Chart 51. ... and a new beginning?
Peak cumulative return, 1987-94 12-month return, Sep 09 - Sep 10 (%) 1800% 60% PHI CHL ARG 1600% 50% INDO MEX 1400% THA TAI 40% COL MAL 1200% TUR 30% ISR INDO IND 1000% PER SIN PHI 20% BRA SOU 800% THA ARG MEX TAI
TUR 10% POL RUS 600% KOR CHL HKG 0% 400% MAL HKG KOR HUN CHN 200% IND -10% CZE BRA SIN SOU 0% -20% 0 5 10 15 20 25 30 35 0 100 200 300 400 500 600 700 1988 MSCI market cap (US$bn) 2010 MSCI market cap (US$bn) Source: CEIC, Haver, Bloomberg, UBS estimates Source: CEIC, Haver, Bloomberg, UBS estimates
And although total performance has been far more muted in the past 12 months, we already see early signs of a similar bifurcation today. Chart 51 shows the current relationship between market capitalization and 12-month returns; the fit is not perfect, of course, but if you strip out the underperforming CE3 markets (Poland, Hungary, Czech Republic) it’s about as close as could be. Markets with current capitalization under US$100 billion have generally been “popping”, while larger markets haven’t. So in our view it’s worth keeping an eye out here.
Interest rates and inflation
Our second point concerns the long-term level of interest rates. Looking back at Charts 15 and 16 above, one of the most striking features of the post-crisis situation is that both short- and long-term interest rates in the EM world as a whole have followed global interest rates right down (with a continued significant gap in levels, of course) in a virtually one-to-one fashion.
And turning at Chart 48, the other crucial point is that the correlation between domestic and global rate movements has been tightest for those countries with the highest capital inflows and the highest overall intervention pressures. The only places that have allowed gaps to widen significantly relative to pre-crisis norms are economies like Argentina, Venezuela, Vietnam, Egypt, China – i.e., economies with sizeable deficits, effectively closed capital accounts or strong idiosyncratic macro risks.
In our view, interest rates in the rest are likely to remain constrained as long as global interest rates remain low; at the short end, because central banks will be unwilling to hike too aggressively in the face of strong inflows, and at the long end because of the strong global bid for yield.
This arguably doesn’t matter much for countries like the Baltic or Balkan states, Ukraine or others now suffering from very weak growth and structural balance sheet repair pressures, as an inflationary credit cycle is unlikely to develop in any case – but it could be an issue in Asian markets like Indonesia, India, Thailand and the Philippines, higher-growth Latin American economies such as Brazil, Peru and Chile, as well as potentially Turkey, Poland and perhaps even Russia.
In this environment the main medium-term surprise could be excessive acceleration in credit growth and inflation in response to unusually low real interest rates, a process that would become even more exacerbated as inflation itself picks up. And although we haven’t discussed global commodity prices (a theme very much beyond the scope of this report), if a strong developed liquidity bid pushes commodities up as well this would only feed further into medium-term EM inflation.
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And this in turn raises greater concerns about the potential for contagion in local property markets, rising domestic and external leverage and a gradual worsening of macro balance sheet conditions over time.
Again, it’s very early days at present, more akin in our view to 1990-91 than to 1994 or 1997. But we will be watching these themes closely going forward, and expect to have plenty of opportunity to revisit them in future reports.
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Notes:
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Notes:
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