Submerging Markets

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.

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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.