Will Emerging Markets Decouple From New York, London?
John Taylor, chief investment officer FX Concepts
The masters of the universe in New York and London, who paid themselves many hundreds of millions, or even billions, each, for their efforts in 2007, have managed to create quite a financial mess over the past year. And it will take the aforementioned masters several years to work their way out of the mess.
What kind of impact is this going to have on the rest of the world, especially on the newly successful emerging markets? Can they decouple from the financial centres, or will the reduction in dollar and hard-currency funding bring these growth stories to an end?
The US and British financial systems, which are centred on commercial banks, have allowed shadow banking institutions to take over about one-third of the financing volume over the past few years. These unregulated institutions, which have generally funded themselves by borrowing short term from other institutions, with back-up credit lines from banks, have been unable to support their asset books as their financial health came under question.
These organisations, in the myriad of forms that they take, are either in the process of being merged into commercial banks, cutting their asset books to a more fundable size or going bankrupt. As a result, getting a loan from one of these institutions is nearly impossible, and the commercial banks that have suffered significant losses from the advances that they have made to these shadow banks are almost as stingy.
The conveyer belt of credit has broken down. The credit drought will result in long recessions for the developed world. Without expanding credit, economic growth cannot exist. What happens to the country, far outside of the money centres, that has managed to run a current account surplus and has a sizeable reserve position? Can it still grow without money from New York or London?
In the 1991 to 1993 period, during the last financial snafu and recession in the US, the emerging markets did extremely well as the low interest rates allowed them to attract whatever capital was available and their equity markets moved sharply higher. Will the same thing happen this time?
Although each situation is different, the chances are fairly good that many of the emerging countries will outperform the major countries in the next two years. Critical to this assessment is the depth of the financial slowdown in the US. So far, the Fed has pushed interest rates low enough and signalled that it would support major investment banks, the largest members of the shadow banking system, but this is no guarantee that these organisations will be able to expand their balance sheets by making loans.
Rates should drop even further and this should reduce losses in portfolios, suppressing deflationary tendencies and further improving asset quality. With low interest rates and robust portfolios, the reserves of the emerging governments will be protected from losses, while making them lousy investments compared to investing in their home economies. As there is much excess savings and unused buying power in these countries, which can be turned into growth in the years ahead, wise policies should unlock this growth while the developed world slows.