Dark Side Of Capital In Emerging Markets

Dark Side Of Capital In Emerging Markets

JAN. 30, 2014


It is no fun to be a central banker in an emerging-market country when investors suddenly grow doubtful.

If you don’t do what the foreign investors say you should do, your currency and your markets will be punished.

And if you do what you are told, well, they could be punished anyway.

Turkey’s central bank set out this week to show that it was changing its ways. After months of watching the country’s currency lose value, and of refusing to raise interest rates despite receiving lots of advice from overseas to do so, it called a news conference for midnight Tuesday, hinting that it would raise rates.

It not only raised them, it sent them soaring. One rate — the central bank has a lot of them — rose to 10 percent from 4.5 percent. That was enough to quiet the talk that the bank was subservient to Prime Minister Recep Tayyip Erdogan, who had loudly opposed any rate increase.

It impressed the currency market — for a few hours. But by the end of the day Wednesday, the bounce was gone.

As a result, noted Michael Shaoul of Marketfield Asset Management, Turkey is receiving “the worst of both worlds.” The higher rates will dampen local economic activity, “while foreign investors are hardly likely to be enticed by increased yields given the volatility and downside potential of the currency. The local crisis would seem to have room to run, and the question for global investors is the degree of international contagion that can be anticipated from Turkey’s woes.”

Not that long ago, Turkey seemed to be a rousing economic success story. Economic growth was impressive and foreign capital was coming in rapidly. Now inflation seems to have taken off, and the Turkish lira is down about 20 percent since the end of 2012. The Turkish stock market has lost a third of its value in lira since last spring.

Turkey’s problems are not entirely economic. The government, which is in the middle of a corruption investigation that forced three ministers to resign and seemed to be pointing at the prime minister, decided to replace the police who were investigating it. Much of the country’s growth has come from construction in Istanbul, and the investigation relates to possible bribes to change zoning rules.

The widespread worry about emerging markets — investors are also nervous about Brazil, India, Indonesia, Thailand, Taiwan and Malaysia, to name a few — can in some ways be traced to the fact that they did remarkably well during the credit crisis that began in 2008. Many of them had hefty foreign currency reserves, and their growth attracted foreign investment.

That investment helped to push up local asset prices, which intensified the boom and brought in more capital. Eventually, money flowed in from investors chasing performance, a sort of “What goes up must keep going up” attitude. The currencies appreciated, and countries began to buy more things from abroad while their industries were losing competitiveness. Current-account deficits began to soar, but that did not immediately matter because the capital was still coming in.

When the cycle turns, as it eventually must, investors who were clamoring to invest can suddenly demand to get out. How much a country is hurt may depend on what form that capital infusion took. Foreign direct investment, like building plants or buying local companies, cannot be quickly or easily reversed. But bank loans can fade away, and those who bought stocks on the local market can sell quickly. The worst problem can come from short-term debt to foreigners, who can get cold feet at the worst possible time.

That is why capital controls can make sense when times are good. Countries that have easy access to loans may be better off not taking them.

Morgan Stanley, which has been among the most bearish on emerging markets in recent months, looked at a variety of indicators this week and concluded that the most exposed countries were Brazil, South Africa, Ukraine and Turkey. It pointed out that a third of Turkey’s external debt was short term and that the country’s foreign exchange reserves were smaller than the amount of its short-term external debt.

Emerging markets swooned last spring after the Federal Reserve began to talk about pulling back on its purchases of Treasury bonds and mortgage securities. The fear was that money would flow out of emerging markets as United States interest rates rose. They got over that when it became clear that scaling back was not going to immediately have a huge effect on markets.

But that plunge, even though many markets recovered, seems to have reminded investors that they needed to focus on market fundamentals and structural issues. And some countries appeared worse than others.

David A. Rosenberg, the chief economist at Gluskin Sheff, a Canadian research firm, looked at six indicators — large current-account deficits, large capital inflows from 2010 to 2012, relatively high levels of fixed investment, slowing economic growth, rising inflation and weak productivity growth.

He found eight countries that he considered vulnerable on at least four of those measures: Brazil, India, Indonesia, Turkey, Thailand, Taiwan, Russia and Malaysia.

What, he asked, happened to all that capital that poured in? “One can reasonably draw the conclusion that, as we have seen time and again, the foreign capital inflow was squandered either on conspicuous consumption or noncompetitive investments,” he wrote.

The last big crisis in the developing world was in Asia in the late 1990s. This one does not seem similar, simply because the lesson most countries learned was that fixed exchange rates were extremely dangerous. (Someone should have told Europe, which was then ramping up for the creation of the euro.)

Now currencies are generally allowed to float, and most of the countries viewed as vulnerable have experienced substantial currency depreciation, which will help their exporters grow more competitive. In 1998 and 1999, some countries lost huge sums trying to defend their currencies, which eventually crashed. Such sudden losses seem less likely now, although some countries have tried to slow the depreciation of their currencies.

The world leader in wasted investment is probably China, the home of easy credit in recent years — credit that was often hidden from official statistics. That country has enough foreign exchange to weather a lot of write-offs, but if it does get into severe difficulties — something that has been predicted for years by some bearish investors — that could have significant consequences. Morgan Stanley now figures that countries that export a lot to China are more vulnerable than those that do not.

Morgan Stanley warns of a possible “suddEM stop” for one or more economies, a play on the abbreviation for emerging markets. But even if you are sure that is going to happen, forecasting the timing is far from easy.

Early in 1994, Rudi Dornbusch, an M.I.T. economist, wrote a prescient paper arguing that the Mexican peso would have to be substantially devalued. But the peso held its own until December, only to lose a quarter of its value in a few days. “The crisis takes a much longer time coming than you think,” he later said, “and then it happens much faster than you would have thought, and that’s sort of exactly the Mexican story. It took forever and then it took a night.”


About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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