As CDOs lose their lustre, leverage has moved on - and might have found its new home in the emerging markets.
“It is quite likely that, as one boom bursts under the weight of leverage, risk capital moves to the asset class where the memory of the last blow-up has receded the most,” said two JP Morgan analysts, Jan Loeys and Margaret Cannella, in a note released earlier this month. The last time there was a major bust in emerging markets investments was in the late 1980s and early 1990s, when there was broad-based default on bank loans to emerging sovereigns. “One might think it is the time for emerging markets to produce the next boom-bust cycle.”
Market participants confirm the emerging markets boom. “In the past few years emerging markets have seen a remarkable growth in assets under management,” said Alia Yousuf, the head of emerging markets at Standard Asset Management in London. But she admits the size of the market relative to other assets is small.
Phil Poole, the emerging markets chief economist at HSBC in London, agrees. “What has also happened is that there has been a portfolio reallocation, where we see money coming out of developed markets institutional investors, and it is not just leverage. We have seen Japanese investors, retail and institutional, diversify and emerging markets have been some of the beneficiaries of that,” he said.
Emerging markets experienced a record $780 billion fund net private capital inflow last year, a 37.3 % increase from $568 billion in 2006, according to figures released by the Washington DC–based Institute of International Finance (IIF). The largest beneficiaries of this inflow were emerging Europe ($365.2 billion) and emerging Asia ($249.8 billion).
In 2008 the boom has slowed. The emerging markets have not been immune to the US subprime-related difficulties. “Risk appetite has clearly dropped following the problems in the credit markets in the west. We are moving from a situation where everything was going right for the emerging markets to where investors are getting all cautious,” said Julian Jessop, the chief international economist at London macroeconomics consultancy Capital Economics.
But, he said, despite this, these markets have held up well. IIF forecasts a drop of only 6.28% in net fund inflows into the markets in 2008, which is a small amount compared with the 90% drop in CDO new issuance from $165 billion in the first quarter of last year to a meagre $16.7 billion in the comparable period this year.
With such a high level of interest, some fear that the level of leverage could spiral out of control, and quickly bring on another bust. Booms usually start with strong positive fundamentals that are taken to their extreme through momentum and leverage.
Some believe the level of leverage might already be at increased levels. “I don’t think it is fair to say that it is about to happen - I think it would be fair to say that in a sense it has already happened,” said Poole. “There has already been a lot of leveraged money that has been inside emerging markets- in carry trade and currencies and some of the credit and equity markets as well – so part of it has already been driven up by leverage,”
However, Loeys and Cannella argue leverage levels and asset prices are still too low to suggest a crisis: “The signs of an imminent emerging market crisis are not in place,” they said.
Jessop agrees. “I doubt that emerging markets are going to reach the high levels of leverage that structured products had reached,” he said. “I think people have learnt their lessons. Certainly among the banks there will be no appetite for taking on the level of risks they have done in credit markets.”
The IIF estimates that, of the total fund inflows into these markets in 2008, only 27.8% is expected to come from commercial banks. “Maybe some hedge funds might not feel so constrained. But then hedge funds are always looking for new areas to lose money,” Jessop said.
Even if emerging markets are spared, Loeys and Cannella concluded, the next bubble is inevitable: “The history of the past 30 years of liberalised capital markets does show that we eventually do again commit the sins of leverage and overconfidence and produce the next boom-bust cycle”.