When the world started to melt
What will go wrong next?
Asian banks: Now comes the real crisis
Asian research: Worth the paper it's printed on?
Peregrine's still flying
Country Risk December 1997: It could be worse
Global Economic Projections: Overall Rankings
According to their fans, hedge funds fared best in the October/November turmoil in emerging markets. Hedge funds, traditionally risk-averse, can steady their returns in volatile times. They tend to run offsetting long and short positions designed to profit from pricing anomalies and low-risk arbitrage.
Funds such as unit trusts and mutual funds, which can run only long positions, naturally fared worse as the markets dived. Some other open-ended, long-only funds suffered huge redemptions as investors fled the most volatile markets, especially south-east Asia. "There's a limit to what you can do," says a beleaguered long-only fund manager. "You can raise cash to maximum limits and head for markets that have fallen already." Another reasonably successful long-only manager relies on "good stock-picking and picking non-correlated countries". But with global contagion, and an exodus of US investors from emerging-market mutual funds, earning a positive return is increasingly difficult. In the meantime, hedge funds have been able to sell futures, borrow stocks and write index swaps with investment banks.
But the triumph of the hedge funds in emerging markets may be short-lived. Because in a persistent down market, hedging becomes ever more difficult and expensive. Hedges against a bear market are best put on before a market turns bad, not during a decline. And if the prophets of doom are right, the hedges that the hedge funds had in place will expire long before we emerge from this downturn, apart from any long-term index swaps. Few conventional short-term hedges can be rolled over efficiently. Eventually, investors that entered emerging markets seeking high short-term returns must either get out or lower their sights and lengthen their time horizon.
|Table 1 - Top five hedge funds in October |
(of those monitored by TASS)
|Name||October performance %|
|Columbus Emerging Markets Fund||4.60|
|SR Global Fund: Emerging Portfolio||2.94|
|Condor Liquidity Fund||0.20|
|Income Partners - Asian Convertible||-0.28|
|Pactual - Orbit Debt Fund||-1.01|
|Note: The worst performer was down 27.19% for the month. But some funds were slow to report. (TASS's comment: "We find that there is a very close correlaton between performance and the speed at which TASS receives the performance information after the end of the month.")|
|Source: TASS Management|
Bid-offer spreads on stocks and bonds widened dramatically from November 3. Combined with soaring interest rates in most markets, that made the transaction costs of arbitrage between pairs of securities too expensive. The market for convertible bonds has died, because few people now expect stock prices to hit their conversion rates during the life of the bonds. Options on Brady bonds and other securities are a thing of the past.
That is the damage wrought by a few weeks of reality after years of euphoria. Liquidity in certain markets turned out to be its own enemy, since liquid securities were the first to be sold in the flight to quality, or in the pressure to meet margin calls. The best-performing emerging markets turned out to be those less dominated by foreign investors, or those so illiquid that foreign investors despaired of getting their money out. Malaysia, Thailand, Hong Kong, Japan and Brazil suffered while India, Pakistan, Turkey, and African markets generally did not. Sellers of the less liquid Russian stocks could find no buyers, so in the end they didn't sell. Because valuations of such stocks are static, that makes them look good. But for how long?
There is an irony here: the markets most liberal and open to foreign investment suffer the biggest capital outflow, while the more sticky emerging markets hang on to their foreign capital and even attract more. "Half of our portfolio is in countries where there's no impact from global capital markets and they aren't pumped up by credit," says Michael Balboa at VZB Partners in New York. He mentions Tunisia, Egypt, Pakistan, Sri Lanka, India, Ecuador, Uruguay and "frontier markets such as Latvia, Armenia and Romania".
Balboa says the warning signs of what he calls a "global liquidity crisis" have been around for some time. Jeph Gundzik, managing partner of Condor Advisers in Salt Lake City, Utah - he moved there to enjoy snowboarding at weekends - warned his select clients, including Balboa, in September 1996 that the Thai baht was heading for a fall. In May, recalls Gundzik: "I wrote to my clients that I had developed the idea of a global liquidity squeeze." This, he explained, would be caused by "the contraction of excessive leverage, through asset-value deflation and bankruptcy".
Gundzik isn't alone as a prophet of doom. But his analysis concentrated on the alarming growth of domestic credit in some countries, especially Malaysia and Thailand, where private-sector credit is up to at least 140% of GDP (see chart). Mexico's private-sector credit at the height of the peso crisis in 1994/95 was less than 40% of GDP. Gundzik maintains that a good chunk of the Malaysia and Thai credit was used to play the stock market - perhaps 10% to 15% of outstanding loans.
Such expansion of credit led to rapid contraction when the stock market turned, says Gundzik: "It happened in Japan. Other Asian countries have to go through what Japan went through." Buyers using credit to speculate in stock markets, who use the stock as collateral to leverage more, are forced sellers when the market turns. That leads to a rapid contraction and erosion of market capitalization as prices fall. Gundzik identifies four stages in this process:
- Rapid credit expansion
- Sudden slowdown in given economies
- Collapse of asset values
- Liquidity crunch
"I don't know what happens in the fifth stage," Gundzik says. But the collapse of asset values can put severe pressure on indebted companies and their creditors, usually banks. In the Mexican crisis, 46% of bank loans turned bad. For Mexico that represented around 12% of GDP, but a similar bad-loan rate in Malaysia or Thailand would total between 60% and 70% of GDP.
Gundzik identifies another vulnerable point in these markets, with far wider implications than the effect of a few hedge funds shorting the currency: the foreign-currency liabilities of domestic companies. Mexican companies rushing to hedge their foreign debt played a part in the fall of the peso in 1994/95. But whereas Mexico's corporate long-term external debt was a mere $5 billion, Thailand's is $10 billion, Malaysia's $20 billion, and Indonesia's a frightening $60 billion (see table 2). "Adding short-term external banking and corporate debt to the equation further underscores the massive foreign liabilities of these countries," says Gundzik.
Balboa, who uses Gundzik's analysis, says liquidity is the factor his fund watches most carefully: "We construct pictures of vulnerability," he says. "If you're an investor you must ask yourself 'how vulnerable are you to a liquidity contraction?' "
But, like all other investors in emerging markets, Balboa has no answer to a global downturn: "This is the first test since 1973," he says. "About every 25 to 30 years the global financial system destroys and reinvents itself."
Gundzik warns, just as Bundesbank president Hans Tietmeyer has recently, against an official bail-out of the system: "It has to run its course. I believe that intelligent central bankers should let it run," says Gundzik. Tietmeyer cautioned in mid-November against using public money to let emerging markets investors off the hook.
To be weighed against that, however, is the observation from many fund managers that they have never before been in such scary markets. "Compared with this, 1994 was a stroll in the park," says one. If we are to see a fundamental change in the structure and behaviour of world financial markets, perhaps the parameters will need to be reset by official intervention. Gundzik points out that, while the Mexican bail-out almost met Mexico's funding shortfall, the bail-outs of Thailand and Indonesia are only a fraction of what is needed (see table 2).
|Table 2 - Balance of capital flows ($ billions): Asian countries versus Mexico|
Foreign private investment
Corporate external debt
Short-term external debt
|Source: Condor Advisers|
As evidence of a structural change, the market in Brady bonds and other emerging-market bonds has become dislocated. "One Brady bond fell 17% in a day," says a bond broker. "I think people were surprised to see liquidity in Bradys disappear in a few days," says Xavier Lepine, president of FP Consult in Paris. Liquidity was reduced to a handful of benchmark bonds such as Brazil C and Russian GKOs. The widened bid-offer spread meant that any shorting or arbitrage operation was prohibitively expensive. "Options have vanished," says Lepine. One dealer insists bravely: "Liquidity is offered to the buy side [ie our clients], but liquidity from other dealers is miserable. You wouldn't be able to unload your position using screen prices."
Given these extraordinary conditions the operations that normally add liquidity, such as securities lending and repurchase agreements, have become more difficult.
As hedges expire, how will fund managers and other participants put on new hedges? "For the globalist," says Dana Moore at Global Asset Management in London, "there are still plenty of places to hide." But for most emerging-market hedge funds, hedging is only a recent phenomenon. "Only 80% of our funds were actually hedging," says George Van, chairman of Van Hedge Fund Advisors in Nashville, Tennessee.
Classic shorting by hedge funds has been selling or borrowing ADRs or GDRs (American or global depositary receipts), or shorting emerging-market stock indexes traded on the Chicago or Vienna exchanges. Obvious liquid shorts have been Lukoil in Russia and the Brazilian Bovespa index. In some markets where stocks are difficult to short, shorting the currency has served as a proxy. Investment banks until recently were able to offer index swaps, whereby a pay-out linked to a stock index's performance is netted against an interest-rate flow.
Another possible bear position is to borrow stock in a listed country fund. Even in normal markets it has been possible to arbitrage the discount or premium at which a country fund trades against its theoretical net asset value. But in volatile markets the bid-offer spread makes such trades uninteresting. "It's difficult to short Russian stocks now," says Lepine. "Everyone is in the same direction."
Securities borrowing may continue, however, provided there are long-only fund managers locked into their investments who are willing to lend out their portfolios. In a bear market, the advantage to the lender is that collateral posted against the stock is more likely to be more than enough, rather than too little, as the stock's price goes down. One collateral manager recalling early November says there was no instance of extraordinary collateral calls.
But the underlying reason for borrowing stock is changing. In normal or bull markets stock is borrowed to create a long/short position - for example, in pairs or baskets of securities from the same sector, or in a convertible bond or warrant against the underlying share. For Malaysian and Thai stocks this had to be done offshore because of government fears of currency speculation.
But Thai regulators, finally persuaded that shorting is mostly used for arbitrage, not speculation, plan to allow shorting of stocks onshore from January 1998. This is ironic, say specialists, since arbitrage is near-impossible in these markets and more naked shorts are being put on.
Stock-repurchase agreements to raise cash or to finance further purchases of stock are a different matter. In these cases extraordinary margin calls are more likely in falling markets, as the stock put up as collateral declines in value. "Repo cash providers are much more sensitive [than stock lenders] to the quality of the collateral," says Roy Zimmerhansl, director for securities lending at Nomura International in London. "Stock lenders are more concerned about the credit quality of the counterparty."
Repo transactions can therefore rapidly exacerbate a contraction of liquidity as extra margin is called from the cash borrower. If the borrower is leveraged he must sell stock into a falling market to cover the position. How much of this was happening with emerging market investors in November? Repo houses are reluctant to say.
Fund managers, whether they are allowed to hedge or not, are facing a completely different world in 1998. Expected returns must decline although the risk in emerging markets stays high. The days when Russian ADRs were trading in New York at 40 times earnings are unlikely to return. "Where was the risk premium?" asks Gundzik.