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Submerging Markets

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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

Growth of hard currency reserve holdings, not economic growth, has been a more reliable predictor of equity market performance in the current market rally. In the decade since the 1997-1998 financial crisis, when such currencies as the Czech koruna, the Thai baht and the Brazilian real came under relentless selling pressure, a dramatic change has taken place. Central banks around the world have bolstered their hard currency reserves substantially. Cumulatively, the increase in reserves has totaled an astounding sum of nearly $3 trillion over the past decade.

Countries that have seen a strong rally in their equity markets have consistently enjoyed massive hard currency reserve growth. Russia’s central bank reserves rocketed since the country’s default and devaluation in 1998 and reserves dwindled to under $10 billion. Russia is a major oil and gas exporter, and a rise in commodity prices and higher domestic output of crude bolstered its reserves (excluding gold) to $300 billion last year.

Brazil’s foreign exchange reserves doubled, to $76 billion, from 2002 to 2006, as its current account swung from a $7.6 billion deficit to a $14 billion surplus. Mexico’s reserves rose by over 50 percent, to $82 billion. Poland’s reserves increased by $20 billion over five years and Hungary bolstered its reserves by $10 billion. Despite running a current account deficit, India’s central bank reserves tripled since 2002, to almost $200 billion at last count.

Central bank reserves cushion emerging economies from currency crises. Successful speculative attacks that triggered financial and economic turmoil in Thailand, South Korea, Indonesia and elsewhere in the late 1990s have become a thing of the past. This, in turn, has reduced risk aversion among international investors, encouraging them to invest in emerging equity markets and bonds.

However, much of the recent build-up in hard currency reserves has been involuntary. Central banks are increasingly forced to step into the foreign exchange market to buy excess dollars from exporters, in order to prevent sharp appreciation of their currencies against the dollar. Dollar purchases, in turn, increase the amount of domestic currency in circulation, which finds its way into equities.

A Trillion-Dollar Question

China is a particularly interesting example — since the global market sell-off in late February started in its two domestic stock markets in Shanghai and Shenzhen. Quite apart from its dramatic economic growth in recent years, China has been running an ever-widening trade surplus, sucking in dollars which the U.S. economy relentlessly pumps into the global financial system. The People’s Bank of China — which is what the world’s premier emerging capitalist nation still calls its central bank — now holds a cache of reserves valued at $1.1 trillion.

It is a well-known fact that bubbles inflate the fastest just before they are about to burst. China’s trade surplus grew especially rapidly in early 2007. Its exports rocketed 33 percent year on year in January, and more than 50 percent in February. But China is only part of a broader picture. Asian reserves jumped to $3.2 trillion in February, up 15 percent from the same month of 2006. Reserves increased nearly $44 billion from January, the fastest pace in three months.

The influx of liquidity will doubtless support stock prices, and may reverse the current equity market sell-off. But it will also be adding to overall market overvaluation. As with all bubbles, the longer they inflate, the worse the eventual deflation. Venezuela’s experience should provide a cautionary tale. Although most analysts focused on the selling in China in late February as the starting point of the latest equities downturn, the first market decline of 2007 occurred in Caracas. In January, it lost one-third of its value in a matter of days as the stock market bubble burst suddenly.

Alexei Bayer runs KAFAN FX Information Services, an economic consulting firm in New York; reach him at [email protected]. His monthly “Global Economy” column in Research has received an excellence award from the New York State Society of Certified Public Accountants for the past four years, 2004-2007.


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