Emerging Markets, and the Global Monetary Merry-go-Round

Good new report from HSBC out making a variant on the emerging markets decoupling case, while launching an emerging markets index (EMI). They argue that the global monetary merry-go-round continues to spin – for while.

I’m less sanguine than they are about decoupling – in the absence of a safety net it is hard to see how domestic consumer spending ramps up in China – but the monetary point is a fair one. Read on:

emiOur optimistic views on the emerging world are also based on what we call the monetary merry-go-round. Low US interest rates typically encourage capital to flow into the emerging world. Attempts by emerging nations to limit the resulting exchange rate appreciation lead to offsetting capital outflows in the form of rising foreign exchange reserves which are often invested in US Treasuries. Higher demand for Treasuries keeps yields low and, hence, leaves US interest rates low, thereby allowing the merry-go-round to repeat, seemingly ad infinitum.

The merry-go round leaves the global cost of capital too low.  A hunt for yield develops. Before the credit crunch, this hunt led to huge investments in mortgage-backed securities which, in turn, fuelled the US housing boom. Post-credit crunch, however, the hunt for yield has gone elsewhere. Investors are now keen on the emerging nations with their strong secular economic prospects.

The implications are simple. Emerging currencies will be under upward pressure, their asset markets should appreciate and their sources of growth should switch from exports towards domestic demand, thereby helping to narrow their, in some cases, large current account surpluses. Indeed, the EMI shows that total order books are rising at a faster pace than exports, supporting the view that recoveries are domestically-led. 

In the absence of an imminent upward move in US interest rates, the merry-go-round should be able to spin a few times more. There are, however, limits to this process.