Asset prices are soaring in emerging markets as investors, borrowing cheaply in mature economies, search for higher-yielding investment destinations. Though prices are not yet historically abnormal, they may challenge recovery efforts there. Policy makers there must tread a narrow path, maintaining international competitiveness and asset price stability without aborting recovery. The longer the price surge continues, the sharper the dilemma. How quickly monetary policy is tightened in the industrial countries and China will play a crucial role.
Asset Prices Are Soaring
Equity, bond, and real estate prices have surged in emerging markets.
- The MSCI Emerging Markets Index has gained 74 percent for the year to date. The Shanghai composite, Indian Sensex, and Brazilian Bovespa equity indices each climbed by more than 70 percent this year.
- In contrast, the Dow Jones and the Nikkei rose only 18 percent and 12 percent, respectively, since the beginning of the year. Stock prices in France have risen little more than 13 percent, while those in the UK gained only 16 percent.
- The EMBI+ Composite Index, which tracks returns on developing nation bonds, has risen 29 percent since March.
- Real estate prices in 70 major Chinese cities rose 3.9 percent in October from a year ago. Home prices in Singapore rose 15.8 percent in the third quarter from the previous quarter, the fastest rate in 28 years. Hong Kong home prices had risen 28 percent this year as of October 18.
What Is Causing the Surge?
As fears of economic Armageddon eased, investors increasingly reduced holdings in low-yielding “safe haven” economies in favor of emerging markets, where growth is stronger and post-crisis public debt and private sector deleveraging are smaller concerns. Low interest rates in advanced countries and large liquidity injections worldwide have also made the “carry-trade” easier and contributed to the surge.
- The Fed has maintained its benchmark rate in the 0 to 0.25 percent range since December 2008, the Bank of England has kept its rate at 0.5 percent since March 2009, and the European Central Bank has held its rate at 1 percent since May 2009. Before Lehman’s collapse in September 2008, those rates were 2 percent, 4.25 percent, and 5 percent respectively.
- Credit-driven stimulus programs, like China’s provision of $1.3 trillion in new loans this year, have fueled liquidity.
- Emerging markets and developing countries, particularly in Asia, have led the global rebound, with the IMF projecting average growth of 1.7 percent in 2009 and 5.1 percent in 2010 in those countries, compared to -3.4 percent and 1.3 percent in advanced countries.
- In addition, the perceived risk of investing in emerging markets has eased, with the cost of insuring against emerging market sovereign bond default having fallen to an average of 262 basis points as of November 25, down from a peak of 800 basis points in March (one basis point represents 1/100 of a percentage point).
- Early depreciations of emerging market currencies temporarily made assets appear cheaper, potentially fueling initial sales. The Brazilian depreciated to 2.7 reals per U.S dollar in December 2008, up from 1.6 in August.
Not Yet a Bubble
Despite this surge, prices are still well below highs seen in the recent past. Price-to-book-value ratios, which measure the premium the market is willing to pay for a company above its tangible assets, are near average levels. Moreover, inflation in emerging markets remains mild, suggesting that the asset price spike has not spread to the rest of the economy.
- Despite strong recent performance, the MSCI Emerging and MSCI Asia Pacific indices are still nearly 30 percent below 2007 peaks.
- According to UBS, stocks in Asian emerging markets currently trade at about two times their book value—about the average ratio for the past 20 years. From 2004 to 2008, the average ratio hovered near three.
- China’s consumer prices fell 0.5 percent (y/y) in October, marking the ninth consecutive month of decline. Brazil’s annual inflation slowed for an eighth month, falling to 4.17 percent in October.
Surge Poses a Moderate Risk to the Global Recovery So Far
These price surges could cause or temporarily conceal bad debts in a number of smaller economies, hurting investors who have turned to these markets. However, unless these surges continue, the risk to the global recovery will be contained.
- Dubai World’s recent near default illustrates the potential shocks that debt from bursting asset bubbles can cause.
- Similar problems could and probably will emerge in other economies which have been badly hit by the crisis, and where government finances are stretched, including Ireland, Greece, and the Baltics.
- However, the global recovery will continue to depend mainly on the healing of large economies. Shocks from these smaller economies should remain manageable – provided a mix of support from national governments, the EU, and G8 is forthcoming. The IMF’s large war chest will help.
A Continued Surge May Hurt Emerging Markets and Challenge Policy Makers
Strengthening capital flows are straining emerging markets by driving up exchange rates. Policy makers there face a familiar dilemma: tightening monetary policy could quell asset bubbles by limiting domestic liquidity, but it could also endanger domestic recoveries, encourage further capital inflows, and put additional upward pressure on exchange rates.
- The Brazilian real has gained 25 percent against the U.S. dollar since the beginning of the year and the Russian ruble gained 7.5 percent in the last three months.
- Hoping to minimize further exchange rate appreciation, leaders in Brazil have imposed a 2 percent tax on foreign inflows. Russia bought $700 million of foreign currency to cap ruble gains. Taiwan banned foreign funds from making savings deposits to stop speculators from driving the Taiwanese dollar higher. Other countries are considering similar measures, and the IMF has condoned them, while expressing skepticism that they can be effective.
- Meanwhile, the renminbi, which is tied to the U.S. dollar, has dropped 7 percent against the euro and 4.4 percent against the Japanese yen since the beginning of 2009, increasing the competitive pressure on other exporters.
- Several countries are looking for ways to stabilize property prices specifically. Singapore may open more land to development, Hong Kong has increased the down payment requirement for purchasing property, and the city of Shenzhen, China, has instated a property tax.
How Quickly Large Economies Tighten Monetary Policy Will Be Crucial
If, as expected, advanced economies continue to recover, faster growth and subsequent interest rate increases may eventually ease the frothy conditions in emerging markets, minimizing the policy dilemma there. But, if large economies keep interest rates loose for too long, faster global growth could instead add fuel to the fire. Tighter monetary policy in the United States and the Euro area is still a way off, but may be edging closer.
- The European Central Bank will conclude emergency lending in December. The rate on the final loans will be indexed to the ECB’s benchmark rate, rather than fixed at 1 percent, giving the Bank room to raise interest rates if needed.
- Unemployment, a key signal for central bankers considering raising rates, fell to 10 percent in the United States last week, but it is not yet clear if this improvement will persist.
- At the same time, weaknesses remain in advanced economies. Factory orders in Germany dropped 2.1 percent in October (m/m) after its cash-for-clunkers program expired.
Looking Ahead
For an update on the unemployment situation in the United States, look for the release of initial jobless claims on Thursday, December 10. The U.S. retail sales report will be released on Friday, December 11.
This analysis was produced by the editorial staff of the International Economic Bulletin, including Shimelse Ali, Vera Eidelman, Bennett Stancil, and Uri Dadush.
