21 August 2007

Shelter from the storm?

By Eric Jansson
on FT Alphaville, 21 August 2007

How will emerging markets respond to the evolving global crisis in financial markets? The question was posed today on Alphaville, the FT’s blog for market banter. Alphaville notes uncertainty as to whether emerging markets could become safe havens during the current storm. It also notes that local risks complicate such markets, giving as an example a spike in kidnappings in Columbia.

The question Alphaville poses is worthwhile. However, it is also indicative of the tendency among fund managers in highly developed economies to view EM as a homogeneous investment zone, whereas, in fact, EM is an extremely heterogeneous area of investment.

The temptation in the current crisis, as always, is to oversimplify in order that the response can be kept simple. Investors in EM prefer large-cap investment vehicles large-cap, that is, within the context of EM economies and they tend to analyse market behaviour accordingly, with a focus on macro trends. By contrast, the example of a spike in Columbian kidnappings implies that micro factors "on the ground" can also become driving forces. This is a fair point because a big challenge in judging EM performance is understanding the interplay between solid macro and fluid micro factors.

EM macro-micro interplay is frequently irrational. EM across the board often feel pain when risk-aversion grows in highly developed markets, despite continuing improvement of local fundamentals. Why? Because developed-market investors in EM stocks and bonds often categorise their EM holdings as "high-risk", and broadly these investors move out of high-risk investments globally when risks in their home markets increase. This phenomenon can amplify risk in EM capital markets. It also magnifies the difficulty of understanding local market volatility and reacting to it profitably. Likewise, micro to macro, when local micro problems spike under globally risk-averse circumstances, EM frequently experience a degree of foreign capital flight.

Beneath the froth of foreign capital investment, obviously, EM reactions are diverse because markets are diverse. The important question today is how important this froth is in each individual market, and how well each market can stand on its own if that froth starts to evaporate or curdle.

In smaller emerging markets, as the current credit crisis plays out, the reaction might well be small; froth is minimal in such markets because large-cap vehicles are scarce there. By contrast, some froth is likely to evaporate or curdle in larger emerging markets, yielding a measurable reaction (note the Asian and Russian reactions) yet at the same time local capacity to weather the storm can ultimately prove greater in large markets with substantial local capacity.

The only answer, at the end of the day as in the US credit market is to understand individual investments in their real context. In EM, the real context means the local context of specific EM economies, companies and industries. There will be some uniform trends, but impact will be diverse, dependent upon proportional levels of exposure. Meanwhile, for clues, look at the way individual EM stock markets have responded so far. Those least touched by big foreign funds show trends divergent (positively) from those we are witnessing in major markets worldwide. The bad news is that some such markets could be real safe havens, yet some undoubtedly are not, and data describing exposure to froth is scarce.

Such are the realities of economic interdependence in a complex world.

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