Emerging stock markets suddenly swooned in late February and early March, in a worldwide bout of selling triggered by a sharp decline in Chinese stocks. China may be a global manufacturing powerhouse, but it is no finance giant. Its stock market capitalization, even after more than doubling since the start of 2006, measured just $1.5 billion, or just over 5 percent of Wall Street market cap.
The global equity rally since 2003 has been largely driven by excess liquidity sloshing about the world financial system, which has pushed asset prices higher across the board, from real estate and fine art to stocks and bonds. This is not the first time that investors have developed jitters. In May through June last year stocks fell by a comparable margin, but the plethora of liquidity promptly helped turn the markets around, transforming a sell-off into a buying opportunity. The same may be true in 2007 — except eventually the liquidity pyramid is bound to come crashing down.
The Caracas Paradox
Consider the strange case of the Venezuelan bourse. The best performer among the world’s emerging stockmarkets in 2006, its IBC index went from 20,000 to nearly 60,000 by early 2007. The market doubled when measured in U.S. dollars, even though the bolivar weakened last year.
Venezuela’s oil-dependent economy has been growing by over 10 percent a year since 2004, but this is not why its stocks rallied so spectacularly last year. The real reason is official capital controls, which ban investors from taking their money out of the country. Moreover, despite inflation of around 15 percent, the central bank keeps its interest rates artificially low, making real returns on bank savings negative. Venezuelan investors have no alternatives except buying domestic equities if they wish to preserve the buying power of their capital.
Venezuela admittedly is an extreme case, but excess liquidity has provided support for other emerging markets as well.
Emerging stock markets had a very good 2006. The dollar-denominated index of world emerging markets compiled by Morgan Stanley Capital International (MSCI) gained over 30 percent last year after a similar gain in 2005, which in turn followed a good 2004 and a spectacular 2003.
As can be expected, rapidly growing economies enjoyed strong gains in their equity markets. China, with its perennial double-digit GDP growth rates, saw its domestic stock indices more than double. India, another star performer in Asia, saw its Mumbai Sensex index rise by around 50 percent. A similar percentage gain in Moscow went hand in hand with nearly 7 percent growth for the Russian economy.
But there have been aberrations as well, where sluggish economic growth did not prevent a strong rally in equity prices. In some cases, a disconnect between the real economy and financial markets has endured for several years.
The Bovespa index of the Brazilian bourse, for example, quadrupled between the start of 2003 and 2007, and nearly doubled over the past two years. Yet, Brazil’s GDP growth averaged 2.5 percent over the past five years, and forecasts see growth of no more than 3.5 percent, on average, for the rest of the decade. Mexico’s IPC index doubled since the start of 2005, but its GDP growth, after accelerating in 2006, is expected to slow toward 3 percent this year and next.
Central European economies have enjoyed stronger economic growth in recent years. In Poland, GDP expanded around 5.5 percent last year. But does it justify a nearly fourfold jump in Warsaw stock prices since the start of 2003? A similar increase was seen in Budapest, even though the Hungarian economy has been slowing since 2004. It will stagnate further over the next two years, at least, as the government tackles its massive budget gap.
Hard Currency Reserves