Thursday, December 8, 2005

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Our comparative advantage in risk

Paul Blustein frets in the Washington Post that many developing countries are heading for another financial bubble:

International money managers are pouring funds at a record pace into the emerging markets of Latin America, Asia, Eastern Europe and Africa. Cash is gushing into mutual funds that specialize in emerging markets, and billions of dollars more are flowing into such countries from giant insurance companies and pension funds.

Turkey's stock market is up more than 50 percent this year; Mexico's is up more than 30 percent; Egyptian stocks have more than doubled. And investors are snapping up bonds issued by emerging-market governments with remarkable gusto.

Therein lie the makings of future disasters, in the view of many economists, market veterans and policymakers. Having pumped large sums into emerging markets at a time of low interest rates and high prices for the commodities that many developing countries produce, investors may well bolt when conditions deteriorate, with the sudden outflow of cash devastating economies and plunging governments into default.

"I worry that there's this perfect storm coming for emerging markets," said Kristin J. Forbes, a Massachusetts Institute of Technology economics professor who served until early this year on President Bush's Council of Economic Advisers.

To hear professional investors tell it, their current bullishness is based on the vastly more prudent economic policies that emerging-market nations have adopted. They cite the higher ratings bestowed by credit agencies such as Moody's and Standard & Poor's on countries that only a few years ago were plagued by defaults and currency devaluations. For example, government bonds issued by Mexico, Russia and Poland now qualify as "investment grade."

"Those ratings have come from fundamental improvements in monetary and fiscal policy," said Dario Pedrajo, senior portfolio manager at Biscayne Americas Advisors. "Deficit spending has declined considerably in emerging-market countries."

But skeptics contend that the main reason for the boom is the paltry level of interest rates in the United States, Europe and Japan, which prompts money managers flush with cash to scour the globe for investments providing at least slightly better returns. "There's just a huge amount of money sloshing around looking for a place to go," said Desmond Lachman, an economist at the American Enterprise Institute who, as a Wall Street research analyst, was one of the first to predict doom for Argentina well before its 2001 default.

The problem, Lachman and others said, is that the influx of cash makes the financial strength of many countries look better than it really is -- and deludes government officials into believing that their policies must be near-perfect. "Even Turkeys Fly When the Winds Are Strong" is how Lachman put it in the title of an article he published recently in the magazine International Economy.

Lachman's article is mostly about Latin America -- but this paragraph captures his jitters pretty well:
What is also surprising is how little attention Latin American investors seem to be paying to the gathering storm clouds over the global economy. How long do they think that global economic growth can be sustained at its recent pace with international oil prices likely to remain at their currently heady levels? Or how long do they think that international commodity prices will remain well bid in a world in which the Chinese economy slows under the weight of its deep macro-economic imbalances and in which Europe stagnates at a time of internal dissension and policy paralysis?
There appears to be an enormous irony in the pattern of global investment flows right now. As Alan Greenspan recently noted, there has been a decline in the home bias of investment:
The decline in home bias is reflected in savers increasingly reaching across national borders to invest in foreign assets. The rise in U.S. productivity growth attracted much of those savings toward investments in the United States. The greater rates of productivity growth in the United States, compared with still-subdued rates abroad, have apparently engendered corresponding differences in risk-adjusted expected rates of return and hence in the demand for U.S.-based assets....

[S]tarting in the 1990s, home bias began to decline discernibly, the consequence of a dismantling of restrictions on capital flows and the advance of information and communication technologies that has effectively shrunk the time and distance that separate markets around the world. The vast improvements in these technologies have broadened investors' vision to the point that foreign investment appears less risky than it did in earlier times.

Accordingly, the weighted correlation between national saving rates and domestic investment rates for countries representing four-fifths of world gross domestic product (GDP) declined from a coefficient of around 0.97 in 1992, where it had hovered since 1970, to an estimated low of 0.68 last year.

The irony is that this home bias is affecting U.S. investors as well -- the Blustein article demonstrates that even as massive sums of savings from the developing world are making their way to the safe haven of the United States, institutional investors in this country are channeling more funds to the developng world.

Does this make any sense? Most people would instinctively say no, and Blustein's implication in his article is that this crazy. My hunch is that it makes a fair amount of sense, because U.S. capital markets and financial institutions possess both a comparative and absolute advantage in coping with risk. This allows them to place large bets in developing country equity markets and earn a higher rate of return than those investing in the U.S.

Then again, I don't have large sums of money invested in the Turkish stock market. Large, wealthy investors are heartily encouraged to post comments on how sanguine they feel about global equity markets.

posted by Dan on 12.08.05 at 10:24 AM


Markets are as good as their regulatory and legal services. The SEC, the Accounting agencies post Enron and the local legal authorities(think Spitzer) can do a good job when they are funded properly and the large firms that bring companies to market do their jobs(failures like REFCO are prettty uncommon on that end).

The markets overseas do not have the record or the personnel often to provide the regulatory and legal status to protect investors. Many because they are new to the job and some because of endemic corruption. Those in the PRC probably present the biggest problem because regardless of your class of stock the govt of the PRC is the largest shareholder and transperancy is not an issue for them; political stablity is. For many other new markets the problem lies in the accounting systems to provide accurate information about how the company is doing on a fiscal and financial basis.

The biggest risk lies in the fact that unlike in the late 90's, the US is unable to provide liquidity to the system to keep it stable during a crisis. As the biggest holder of US currency and debt is now the PRC but is also the biggest operator in the commodity and merchantile marketplace it will be interesting to see if they can respond.

We have had another example of state vs private operator conflict in the copper market in the last two weeks. A Chinese national has a huge position in copper which is reported to be actually the PRC's(the national's status as a representative of the PRC trading arm is in question) and it is in default. It sounds like a potential Barings Bank scandal but unlike poor Nick it does not have a capitalist sponsor to be held responsible for the loss. It is hard to be a capitalist and not want a piece of that pie.

Other problems for those small markets is that due to lack of liquidity there are index's representing baskets of those countries leading stocks. Under SEC rules you do not have to own the physical to create a basket. They are often exempt from the down tick rule for shorts so we could potentially have a waterfall effect should a decent sized market under an exogenous event and everyone wants to get out of their paper. While we eliminated this problem for our market after Oct 1987 iwould not want to be sanguine about the possiblity.

Remember these countries probably have dollar denominated debt and pegged or fix currency problems to deal with as well.

All in all you want to play these types of market places with money in your risk account not your retirement one.

posted by: Robert M on 12.08.05 at 10:24 AM [permalink]

This is simplistic (not Dan; Robert M). Many people have persuasively demonstrated that the SEC and the FASB and especially Spitzer are bad, not good, for our markets (or at least they often are). It's not that our markets and institutions are so heavily regulated that makes them attractive (and, to Dan's point, able easily to bear risk). In part, in fact, it's the relative paucity of corporate and securities regulation that keeps our markets and our corporations strong. But, most important, it's surely the rule of law and the protection of property rights (not only from others but also from the government) that facilitates massive liquidity and risk bearing. It's not what the SEC can do, it's what it can't do that separates us from China. It's the enforceability of contracts and the fairly well-observed distinction between "private" and "public" that support our institutions and markets. A strong SEC on this view is mostly a signal not that small investors will be protected by the government (they won't) but that the markets function so well that they can absorb even fairly substantial and continuous interference from the likes of the SEC.

posted by: geoff manne on 12.08.05 at 10:24 AM [permalink]

I just wanted to say what a pleasure browising your sight! Wonderful sense of hummer! Above my head on investing! :-) Have a great weekend!

posted by: Joe on 12.08.05 at 10:24 AM [permalink]

Does this make any sense?

Certainly it makes sense. Both groups of people diversify and reduce overall risk by investing in other countries. You can reduce your risk even by investing in a risky market if that market moves in a way not correlated with your home market. In this case, US people hedge against the US market growing more slowly than developing country markets, and people in developing countries do the reverse. It makes sense for both.

posted by: John Thacker on 12.08.05 at 10:24 AM [permalink]

> Many people have persuasively demonstrated
> that the SEC and the FASB and especially
> Spitzer are bad, not good, for our markets
> (or at least they often are)

Almost all of the ex-Enron ex-retirees subscribe to that theory, for example. At least when they have time to think about it after finishing their 24-hour shifts locked into the local Wal-Mart.


posted by: Cranky Observer on 12.08.05 at 10:24 AM [permalink]

A basic result in financial economics is that if a risk-free asset (meaning cash) exists, then the only difference between the optimal portfolio for an investor able to handle a lot of risk and and the optimal portfolio for a more risk-adverse investor is that the latter will hold more cash. I'm not in a good position to say whether the theory underlying this result matches the real world. If it does, then a comparative advantage in risk cannot exist; the actors will equalize the playing field by holding more or less cash, depending on their aversion to risk.

posted by: Kenneth Almquist on 12.08.05 at 10:24 AM [permalink]

geoff manne says that the rule of law makes out markets great but the institutions that enforce those laws are bad for the markets. Does that seem as internally inconsistent to others as it does to me?

posted by: spencer on 12.08.05 at 10:24 AM [permalink]

Is there any economic activity that doesnt have the seeds of impending disaster built into it?

posted by: Mark Buehner on 12.08.05 at 10:24 AM [permalink]

Interesting choice of gloom&doomsters in the WAPO article: AEI, Bush CEA staff, a guy from well co-opted Citigroup. In view of the administration's PR fixation and the paper's willingness to go along, one would guess that this is an attempt to ward off the capital flight that oughta result from reversal of Fed rate hikes (which in turn will be necessary when homeowners' leverage goes negative.) But really, country risk's a reason to diversify with forex, not stay home with our 19 P/E and 4 1/2%.

posted by: psh on 12.08.05 at 10:24 AM [permalink]

Kenneth, Cash has no risk only in the textbooks, because in real world it is one of the riskiest forms of wealth. Cash is a promise to pay - by a government. Governments systematically erode the value of cash, steal or tax your money and put regulations of what you may do with it. If you have to flee, cash is as much of a resource as a source of risk. The surest way of moving resources into the future is by having healthy children.

posted by: jaimito on 12.08.05 at 10:24 AM [permalink]

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