Ultimately, the increase in risk aversion might well prove only a small blip in the larger picture; for the moment, it seems that liquidity has not left the table. But what has clearly happened is that investors have called into question various countries’ growth rates, especially those considered as emerging markets. There are some who believe that claims of local knowledge are more than a mere advertising sound bite but rather the key to understanding more fully what is driving global financial markets.
This year’s emerging market shock failed, at least for the time being, to take hold to anywhere near the same extent as previous crises have. Around a decade ago, the developing markets were highly dependent on capital from the G7 countries. It was this G7 capital inflow that helped maintain their pegged currencies and assisted with the creation of export industries.
Good fundamentals
But in the late 1990s there was a turnaround in the state of emerging market monetary policy. A series of reforms have meant that many of these emerging markets have established the basic fundamentals needed for monetary stability, which has allowed them to benefit from their position as net exporters of commodities. As a result, improvements include the accumulation of sometimes large foreign exchange reserves, reduced current account deficits and the establishment of floating currencies in more than 80% of countries considered to be emerging. This compares with less than 30% in 2006. The establishment of independent central banks, with improving corporate sector balance sheets and increasing FX reserves, has increased the resilience of emerging market economies to internal and external shocks.
"Compared with the early 1990s investors are much more confident that there are much better institutions, which limit the intensity and length of slowdowns through proactive policies," says Bhanu Baweja, head of global EM FX strategy at UBS. "Many central banks have transparent inflation targets, and formal independence has also limited policy mistakes political interference could have caused. That’s why you can sit in Liverpool Street and invest in Colombia and Ukraine."
But, this might not be the story of 2007. Over the past five years emerging markets have been helped by a very strong growth environment. Now, although headline growth has remained strong, there is evidence to suggest that if exports decline there will be a shift of focus from inflation targeting to maintaining an attractive currency. "In many countries we are seeing signs of reform fatigue and it will be important to see if the central bank institutions can retain their function and strength through a slowdown," says Baweja. "Times have been good for the last few years but now these institutions are going to be tested."
As these countries decide to make their own decisions on how to manage their economies, it could be argued that it is essential to have a local presence as the only way to predict currency moves and stay one step ahead of competitors. "As we head into these challenging times it will be even more important to have a local presence in emerging markets," says Baweja. "There will be a premium on timely information with many nascent business opportunities arising." Information is not commoditized as it is in the US or UK. Much emerging markets knowledge depends on personal relationships.
This onshore presence has made Standard Chartered look at recent moves in a different light to many London-based investors. "Our African presence gives us a good understanding of what is going on locally. It enabled us to create a currency basket that included currencies that aren’t in fashion and so aren’t correlated with the major currencies. Recent market moves still left this basket up by 0.5%," says Marios Maratheftis, global FX strategist at Standard Chartered.
The chance to exploit currencies that are not in fashion has made the return of volatility welcome. "For us, being in the right place with the right knowledge, and a good, on the ground, understanding of local fundamentals means this downturn has generated a lot of opportunities throughout the emerging markets," says Maratheftis.
Negative sentiment
But not everyone agrees. Turkey is an example where local sentiment is far more negative than external sentiment. Internal investors tend to react on concerns such as elections, whereas external ones recognize that politics is less likely to have an impact on the independent central banking system. Therefore, external investors are more positive about the lira and the local equity market.
The risks faced by emerging markets have also changed. David Lubin, an economist at Citi, says: "Ten years ago there were many more home-grown problems in the emerging economies that left them vulnerable, but these days emerging markets’ balance sheets are strong. That leaves them less vulnerable to external shocks but, equally, still the biggest single threat to emerging markets’ financial stability is a shock to global growth or liquidity. This means that the benefit gained from local knowledge in emerging markets is a bit less useful than it was 10 years ago."
For the moment, the feeling is that there is still plenty of liquidity around and a US soft landing is likely to keep it there. But if liquidity declines, emerging market currencies are almost certain to come under pressure. Local knowledge will not prevent that happening, but it might well provide first-mover advantage and the ability to sell assets in other markets that have lagged behind. If all remains well, a strong presence in local markets could simply provide the means to provide a distinct service that enables banks to stand out from their peers. And in a world of increasingly correlated markets, the ability to do anything different should prove attractive.