Funds Blowing Foreign Bubbles?
Thursday, December 8, 2005
Remember the financial crisis that laid waste to the Mexican economy in 1995? Or Thailand's meltdown in 1997, which soon spread to Indonesia, South Korea, the Philippines, Russia and Brazil? Or the implosion of Argentina's economy in 2001, which left millions of people destitute?
Just distant memories, unlikely to recur -- or so the world's investors seem to have concluded.
International money managers are pouring funds at a record pace into the emerging markets of Latin America, Asia, Eastern Europe and Africa. Cash is gushing into mutual funds that specialize in emerging markets, and billions of dollars more are flowing into such countries from giant insurance companies and pension funds.
Turkey's stock market is up more than 50 percent this year; Mexico's is up more than 30 percent; Egyptian stocks have more than doubled. And investors are snapping up bonds issued by emerging-market governments with remarkable gusto.
Therein lie the makings of future disasters, in the view of many economists, market veterans and policymakers. Having pumped large sums into emerging markets at a time of low interest rates and high prices for the commodities that many developing countries produce, investors may well bolt when conditions deteriorate, with the sudden outflow of cash devastating economies and plunging governments into default.
"I worry that there's this perfect storm coming for emerging markets," said Kristin J. Forbes, a Massachusetts Institute of Technology economics professor who served until early this year on President Bush's Council of Economic Advisers.
To hear professional investors tell it, their current bullishness is based on the vastly more prudent economic policies that emerging-market nations have adopted. They cite the higher ratings bestowed by credit agencies such as Moody's and Standard & Poor's on countries that only a few years ago were plagued by defaults and currency devaluations. For example, government bonds issued by Mexico, Russia and Poland now qualify as "investment grade."
"Those ratings have come from fundamental improvements in monetary and fiscal policy," said Dario Pedrajo, senior portfolio manager at Biscayne Americas Advisors. "Deficit spending has declined considerably in emerging-market countries."
But skeptics contend that the main reason for the boom is the paltry level of interest rates in the United States, Europe and Japan, which prompts money managers flush with cash to scour the globe for investments providing at least slightly better returns. "There's just a huge amount of money sloshing around looking for a place to go," said Desmond Lachman, an economist at the American Enterprise Institute who, as a Wall Street research analyst, was one of the first to predict doom for Argentina well before its 2001 default.
The problem, Lachman and others said, is that the influx of cash makes the financial strength of many countries look better than it really is -- and deludes government officials into believing that their policies must be near-perfect. "Even Turkeys Fly When the Winds Are Strong" is how Lachman put it in the title of an article he published recently in the magazine International Economy.
Alarming or heartening, the amount of private capital flowing into emerging markets is reaching all-time highs -- a total of $345 billion this year, according to a September estimate from the Institute of International Finance, an organization of multinational banks, securities firms and other financial institutions. Drawing ominous parallels to the period leading up to the Asian financial crisis of 1997-98, William R. Rhodes, a senior vice chairman of Citigroup, pointed out at the institute's news conference that the previous record of $323 billion was set in 1996.
"You remember what happened after 1996," Rhodes said. "We had 1997. We had 1998. We had the default by Russia, and we had Long-Term Capital Management" -- a Connecticut hedge fund whose collapse in 1998 triggered a nosedive in U.S. stock and bond markets.
Another key barometer of market sentiment underscores the optimism that has taken hold -- the difference between the yield on U.S. Treasuries, the benchmark for investment safety, and the average yield on emerging-market bonds. For most of the past decade, this indicator has ranged from 4 to 10 percentage points, but it shrank late last month to a record low of 2.3 percentage points. That means investors are accepting lower interest rates than ever to compensate for the risks of buying emerging market bonds. In recent weeks, buyers of Polish, South African, Malaysian and Bulgarian bonds accepted yields only a fraction of a percentage point higher than they can get on U.S. Treasuries.
On the bright side, developing nations can borrow cash they need relatively cheaply on international markets. However, the same applies to countries with checkered financial pasts, reputations for corrupt government and worries about political instability. In early October, for example, Indonesia sold $900 million in 10-year bonds yielding 7.625 percent, and $600 million in 30-year bonds yielding 8.625 percent.
The money is coming partly from large institutions, such as pension funds that are devoting greater portions of their investments to emerging markets, but also from individuals seeking to cash in on the trend. Mutual funds specializing in emerging-market bonds have had "by far their strongest year of inflows," according to Brad Durham, managing director of Emerging Portfolio Fund Research. Emerging market stock and bond funds tracked by his firm have drawn an estimated $23.2 billion in new funds so far in 2005 -- nearly five times as much as in 2004.
Among the magnets for new cash are the emerging market funds controlled by Pacific Investment Management Co., the Newport Beach, Calif.-based mutual fund giant. About $700 million has flowed into the firm's flagship emerging-market bond fund this year, bringing its assets to about $2.7 billion.
"More and more investors are comfortable with emerging markets," said Michael Gomez, Pimco's chief portfolio manager for emerging-market funds -- and with good reason, he argued.
As evidence, he cited Brazil's faithful adherence to tough budgetary targets. And then there's Russia, which "has done a phenomenal job of self-insuring" against a crisis, Gomez said. The Russian government has used its oil revenue to build up a hoard of foreign currency reserves that recently topped $165 billion, even as the government has retired about $20 billion in debt this year.
Pessimists acknowledge that most emerging-market economies are more conservatively run than they used to be. But they fear that debt burdens remain dangerously high, even for countries with fiscally responsible policies such as Brazil. Moreover, they fret about factors that artificially increase the foreign money flowing into emerging markets.
For example, certain types of hedge funds, which are investment pools for wealthy investors, have been putting money into emerging markets because holding a geographically diverse batch of securities can enhance their safety ratings -- and thus their appeal to clients.
"So you put a little Jamaica in the fund, a little South Africa, a little Thailand," said Christian Stracke, an analyst with CreditSights, an independent research firm. "In a global crisis, all three will be a dog. But if you're a [hedge fund] manager, you don't care. You just want to offer as much diversification as possible, with as much yield as possible."
In recent reports to clients, Stracke has warned about the rising vulnerability of Turkey to a sudden withdrawal by foreign investors. "Turkey is clearly overly dependent on unreliable external capital flows," Stracke wrote in a Nov. 10 report, noting that over the past three years, the country has drawn "a whopping $51.6 billion" in such flows -- short-term bank deposits, for example, that can flee at a moment's notice. The money has helped to offset a yawning trade deficit that has widened beyond market expectations, precisely the sort of circumstances that got other countries into trouble in the past.
Worries were also raised at a meeting in September of finance ministers and central bankers from the Group of Seven major industrial nations.
"It's something we watch closely," said Timothy D. Adams, undersecretary of the treasury for international affairs. "We continue to watch it, because we're paid to worry, and paid to think that benign conditions may be transitory."