New flows to emerging market bond funds reached an all-time high last month. Weekly flows to emerging market equities neared $2 billion. Even central and eastern Europe is benefiting from the predilection for emerging markets.
At around 2.1 times book value and 12 times forward earnings, share prices across emerging markets suggest there is leeway for more. When emerging market valuations peaked in the 1990s, prices were around 20 times earnings and in 2007 they were around 14 times earnings. On both occasions, prices were around three times book value.
Interest rates will remain low in developed countries, assuming the recovery there is gradual. Public debt problems in Greece and elsewhere in the west will continue to underline the better prospects further south and east for portfolio investment. As markets such as India boom, they will continue to increase interest rates. So yields in emerging markets will still be more attractive.
Meanwhile, during the global financial crisis, credit in Brazil, China, India and Russia did not decline as much as portfolio inflows and asset prices. Lending in these countries has remained high relative to trend, according to the IMF. Their economies might be overheating.
For the moment, Brazil’s minerals are in strong demand – above all in China. But just as China’s property market helped prevent the global economy sinking, it is now overpriced in some areas, and it could be a problem.
If investment in real estate wanes, the Chinese government could bolster growth with infrastructure spending. However, Chinese inflation has risen from minus 1.8% last July to 2.4% in March. If inflation reaches the high single digits it will be more of a priority.
Currency appreciation could slow hot money. But China’s approach in this regard of “crossing the river by feeling the stones” is like damming a torrent with pebbles. China’s reluctance to allow its currency to appreciate more quickly makes it more difficult for competitors to allow their currencies to appreciate too.
Capital flows to emerging nations will therefore persist. Even bigger and more influential countries are vulnerable. And while the IMF has become less hostile to capital controls, as the Fund pointed out last month, such controls rarely work.
In 2008, Brazil’s transaction tax on loans and fixed-income securities did not reduce net inflows, or lengthen their maturity, or stem the appreciation of the currency. Croatia’s curbs on bank’s foreign borrowing last decade were a relatively successful capital control.
Yet international banks’ lending is no longer the problem. Indeed, if global lenders were less subdued, flows to emerging nations would be much stronger. Optimism around such countries as Brazil and China now is also far greater than optimism about Croatia five years ago.
To guard against a sudden future outflow, banks in emerging markets must ensure robust risk management, liquidity and capital adequacy levels, and avoid asset concentrations. As the IMF says, governments can help stem the tide with tighter fiscal policy and some capital controls. But in the end it might only mitigate the bubble.
