We mentioned last week how HSBC’s analysts were beginning to worry more about quantitative tightening (QT) moves in emerging markets than further rounds of quantitative easing (QE) in the US and Britain.
Also, as an aside, we mentioned that the threat from currency devaluation wars in the west could be small-fry in comparison.
HSBC’s concern, of course, is that emerging markets are being pressured to act unilaterally due to the inflationary inflows heading into their monetary systems. Specifically — the way in which these flows were heading into their economies.
On Monday, Bank of America Merrill Lynch analysts pick up on the theme too.
As they explain it’s about how these flows are increasingly creating capital rather than current account surpluses that may be the problem (our emphasis):
If Asian policymakers are worried, it is with good reason. As we have written before, the capital inflow flood has barely started. With the exceptions of India, Indonesia and Thailand so far, in every other Asian country the bulk of the reserve accumulation this year has come from the current account, not the capital account.
Again bond inflows have dominated. The hunt for yield will drive portfolio flows. The IMF in its October Regional Economic Outlook notes that since mid 2003, emerging market equities have outperformed developed markets, reflecting diverging macroeconomic fundamentals. In this context it is worth highlighting that even though Asia is currently in the midst of an export-led cyclical slowdown, we expect the region to grow by 7.4% in 2011 compared with 8.8% in 2010. Further, we expect domestic demand, led by fixed investment spending, to start reaccelerating from mid 2011. By contrast, we forecast 1.8% growth in the US next year and 1.5% in Europe.
Inflows could last a while. Econometric analysis shows portfolio inflows tend to persist due to herd mentality. Specifically, inflows to emerging markets increase in response to higher returns and lower volatility of returns, and those higher inflows may lower volatility and increase risk adjusted returns.
In short, it becomes an (un)virtuous cycle. The potential capital inflow is large. According to the IMF, emerging market assets account for around 2-7% of real money inflows currently. A one percentage point reallocation of global equity and debt held by G-4 real money investors, which amounts to US$50tn, would result in additional portfolio inflows of US$485bn.
In other words, while surpluses created by current account flows (i.e. from trade) were tolerated, inflows heading into emerging economies via the capital account are likely to draw much swifter and sharper responsive actions.
From emerging markets’ point of view it’s almost like stealth yield robbery by the west, with some very nasty inflationary consequences attached. It’s understandable, therefore, why many analysts believe most countries may not be prepared to suffer it.
As BoAML put it:
The problem with capital inflow is it pushes up domestic money supply growth. When money supply starts to grow much faster than nominal GDP, it fuels asset price bubbles, economic overheating and rising inflation down the line. Certainly, central banks can try to sterilize inflows but sterilization is expensive when used on a large scale over an extended period. Again, there is a question mark over the effectiveness of both sterilization and other monetary policy management tools in times like these.
What’s more, as BoAML observed back in October, intra-regional trade is now driving overall export growth everywhere bar Hong Kong — which means there’s not as much of an incentive to sterilise flows via currency weakness (against the dollar) as there would have been before.
Indeed, according to BoAML:
Today 44% of Asia ex China exports end up within the region compared with 19% in China, 12% in Europe and 11% in the US. Further, starting last year, intra-regional trade has continued to deepen, with the share of Asia ex-China exports ending up in the region rising, on average, by 1.1ppt in the first half of the year. Moreover, intra-regional trade is currently driving overall export growth everywhere except Hong Kong
(Chart 5).
While intra-regional trade is moderating we expect that it will start to pick up from mid-2011 in tandem with regional fixed investment. Two reasons: First, we estimate that at least 50% of intra-regional exports are for final domestic use. Second, looking at the product mix of intra-regional trade, it is evident that Asian countries are more geared towards each others’ corporate sectors through demand for capital and intermediate goods than the household sectors through consumption goods.
Given all that, the big question should become — what will happen to all that capital and flow if and when it’s prevented from accessing emerging market assets?
Related links:
Emerging markets at risk from a gigantic bubble - FT
Investing in local currency bond markets – NBER
Global imbalances and EM financial markets – FT Alphav