Pumped up

Fears of emerging market bubbles divide commentators, with some arguing that such economies thrive on robust peers, while others insist that policy in the West will have an inflationary effect. Rodrigo Amaral reports.

Kristof Bulkai, a fund manager at Thames River, argues that, although emerging markets are not in bubble territory right now, there is a risk that they will get close to that undesirable status. He says that three basic conditions are required for a bubble to be created, and they have to some extent already been fulfilled. For starters, investors need access to easy money, which is the case today, thanks to the low interest rates in the rich world. By borrowing cheap dollars, sterling or euros to make their investments in the emerging world, investors have a strong incentive to be bold with their bets. “The first thing that starts a bubble is over-cautious monetary policy,” he says. Investors also have to believe in what Bulkai calls “a new paradigm”. In the case of emerging markets, there is much talk about how well they sailed through the global financial and economic crisis thanks to responsible ­fiscal policies and economic diversification, which differentiates their current situation from the state in which they faced previous global crises.

”If the volume of IPOs and secondary issues dry up, and capital inflows carry on growing, then you can see prices going to the moon, and you have a bubble”

The third condition is low aversion to risk, with the memories of the subprime crisis still haunting many people. But observers have pointed out that much of the money lost during the financial crisis has already been recovered thanks to the market reaction of the past year, and there are plenty of investors feeling daring again. “The reason we don’t believe there is an emerging market bubble yet is because we haven’t seen crazy valuations, irrational behaviour or euphoria from the part of investors,” Bulkai says. “But there is a chance that the market will migrate to bubble territory. For that to happen, investors need to start making debt to take advantage of the bull market. Leverage is a very important part of the bubble process.”

But, if bubbles form, where will they appear in the first place? That is an important question for investors. If they can spot a bubble on the brink of bursting, they can not only avoid pain, but also make a killing by selling on the high. Of course the spotting part is the hardest. For example, fingers have been pointed at equity markets in countries such as Chile, Colombia, Indonesia and the Philippines, which have gone through the roof this year. But even there valuations have not been out of order, according to the experts.

Countries with hot property markets could trigger alarms after the bad experience the sector had during the latest financial crisis in America, Britain, Ireland and Spain. But a direct parallel with the rich world might not be the best guide. “I was trying to buy an apartment in Rio, and prices kept going up all the time,” says Mobius. But he says that banks in Brazil have sophisticated risk control practices and could be able to prevent the market from suffering the same excesses as in America. And, anyway, in Brazil and other emerging economies, borrowing against property is not as easy a process as in America or the Britain of about 2006, which makes the creation of a similar property-based credit bubble less likely to take place.

Suspicious minds have hinted that China could be brewing asset bubbles with its policy of keeping the renminbi tagged to the dollar, no matter how weak the greenback is. In April, Gerard Lyons, the chief economist at Standard Chartered, was quoted by the Guardian as saying that “China is not a bubble economy but it is an economy with bubbles”. Analysts say that the Chinese government has been busy trying to prevent a real estate bubble in a country where commercial buildings have been mushrooming, and in some places reportedly at a quicker pace than the demand for office space. But, although there have been warnings for years, no big asset bubble has so far harmed foreign investors in China, and the monetary authorities have been pretty prompt when it comes to taking measures to avoid overheating. According to Tiramani, in equity markets China has been playing catch-up, after the Shanghai Exchange posted sharp losses during the global crisis. “China has been lagging other emerging markets, but it is starting to move again,” he says.

Not all price hikes are relevant for investors either: Bulkai notes that South Korea has faced a dramatic increase in the price of cabbage, an essential food staple in the country, but this particular bubble has caused concern to few people outside its borders. But large inflows of foreign capital could possibly generate a secondary effect that should give pause to investors, namely inflationary pressures. “We are advising our clients to buy some inflation protection in emerging markets through getting exposed to index-linked bonds,” says Philip Poole, the global head of macro and investment strategy at HSBC Global Asset Management.

”China has been lagging other emerging markets, but it is starting to move again”

According to Poole, three factors are contributing to augment inflation risk. There are interventions in foreign exchange markets to avoid further appreciation of emerging market currencies, which need to be sterilised in the domestic market, but not always are, which increases liquidity in their economies. ­Second, food prices are going up, a significant development because they are often a major component of inflation indices. Third, wage pressures are mounting as emerging economies ­perform ever more strongly, reducing unemployment and strengthening the hand of workers eager to enjoy a larger slice of the pie. Inflationary pressures illustrate how difficult it is for emerging market governments to find a mix of policies capable of keeping their economies on the good path while at the same time avoiding the negative effects of an excess of foreign hot money. Poole notes that, if emerging economies tighten their monetary policies by increasing interest rates, they make themselves even more attractive for global investors.

However, policymakers are unlikely to let market forces remain untrammelled. Investors expect more taxes on foreign investments, like the ones imposed by Brazil. And more people have been making a case for the adoption of capital controls by the most important emerging markets. The IMF itself, which once decried such measures, has conceded that capital controls are “part of the toolkit at the disposal of national authorities”, says Viñals. “Several emerging markets are likely to implement capital control measures, in one way or another,” Tiramani says.

Andy Xie, an independent economist based in Shanghai, has argued that capital controls are the only valid option that countries such as Brazil have at their disposal. “To avoid a catastrophe, Brazil must stop capital inflows now and also prepare to stop the money from leaving when the market turns,” he wrote in Caixin Online. “I doubt that Brazil will do that.” But other emerging market experts consider that such a drastic measure would constitute a step backwards and that governments will resist the temptation to implement them. “I don’t think capital controls are the ultimate solution for the major emerging economies,” says Le Coz. “They have been benefiting from the opening of their economies to the outside world.”

But many market players are monitoring the situation closely. “As a foreign investor I’m very concerned with policies to contain inflows of money in emerging markets,” says Mobius. “We don’t mind much a tax on turnover at the stock exchange, but there is ever more talk of capital controls, and it could be a real problem for global investors. I can see why some countries don’t want all this hot money coming in. The problem is that they often don’t distinguish between long-term equity investors like ourselves and short-term currency traders,” he concludes.