Zero Beta

Earlier this year, I asked the question, “What happens if emerging markets stop emerging?” and earlier this week I wondered if we are starting to see Asian Flu Part Deux.

It seems that I am not alone.  The WSJ and Infectious Greed (hat tip Abnormal Returns) published an article today outlining the trouble many emerging market countries are having in supporting their currency and dealing with inflation.  They are now starting to have to pull back subsidies - facing political unrest.  Political stability hurts sovereign credit ratings and today Merrill Lynch downgraded a handful of emerging market debt.

More and more it seems that this time things won’t be different.  Below, I have published a quote from Satyajit Das’s excellent book, Traders, Guns, and Money.  He worked for years on derivative desks across Wall Street and has fantastic insight on derivatives as well as emerging markets.  He has republished this excerpt it on his blog, Fear and Loathing in Financial Products.

Financial markets like aged rock stars periodically flirt with the developing countries – “emerging markets” for the politically correct.

In the 1990’s, Americans and Europeans had “discovered” the developing countries of South and Far East Asia. In earlier decades during a different period of financial exploration, they made similar discoveries in Latin America. Massive foreign investment and loans generally followed the discoveries. Asia was the “newest best new thing.” It generally was, at least, since the last newest best new thing.

It ends invariably in massive losses. There are defaults on loans. The discovery turns out to be not quite what it had promised. There are a few recriminations, usually from investors and shareholders. Senior executives huff and puff – “we acted in the best interest of our stakeholders in pursuing this attractive growth option.” The more literary frequently quote Brutus at Phillipi - “there is a tide in the affairs of men which taken at the flood, leads on to fortune, omitted, all the voyages of their life is bound in shallows and miseries”. Unfortunately, in most of these cases the tide has not led to fortune. Brutus had been defeated at Phillipi.

During my 28 years in the business, I have witnessed more than half a dozen Latin American crises. In the 1990’s, Asia was “hot”. Observers were smitten with the Asian “miracle”. Exactly why was puzzling.

The Asian economies grew rapidly in the 1990’s. Much of this growth was unsustainable. Analysts were taken by the high savings rates. Political instability and the lack of a social welfare system forced people to squirrel away money (especially in Swiss Bank accounts). Analysts focused sagaciously on the growth prospects and high returns for investors. Asian labor costs were low. There were no labour laws. Abundant natural resources were free to be exploited without environmental safeguards. Unexploited domestic markets excited foreign businesses.

There were, of course, “problems”. The sudden increase in the rate of growth and demand set off rapid price rises. The office space in Mumbai’s Narriman Point business district was among the most expensive in the world. This was a matter of Indian national pride. Productivity was pitiful. The phones and plumbing did not work. The traffic was horrendous.

Some experts claimed to know the rules of the game. The shaven headed, black leather jacketed professional skeptic of matters financial leaned against an ill lit bar in Hong Kong’s Wan Chai district. There were “hostesses” in fashionable dishabille all round. This was the Grand Master’s “office”. I listened as he sallied forth.

“There are distinct phases in investment madness in emerging markets. Phase 1 is growth. You get a lot of foreign investment. It is mainly relocation of production facilities. Cheap brown people to do dirty jobs for nothing. You dig up, cut down everything you can. The locals deregulate everything because the World Bank tells them it will attract foreign investment. Government owned businesses are sold cheaply to the favoured sons and their foreign cronies. Government controls are relaxed as the foreigners tell the locals that it will create jobs and wealth.” The Grand Master paused to take a drink.

“In Phase 2, living standards improve for the fortunate. For the bulk of people nothing changes, of course. A middle class develops chasing McDonalds and Wal-Mart consumer heaven. Property prices and shares go crazy. More and more money comes in. Local banks lend recklessly. Foreign banks lend recklessly to local banks. The foreign banks think the local banks won’t fail because of government support. Investors dive in. They talk about “growth” and “portfolio diversification”. People are excited. Prices spiral up as the tidal wave of money pours in.”

“Phase 3. Costs rise to levels that make the economies uncompetitive. They are not cheap any more. Alas, the capitalist caravan must move on. Everything is over priced. Politicians talk bravely about the “need to move up the value chain”. They launch ambitious initiatives – the world’s tallest building, the world’s longest building, a new port in a country which has no sea access, bridges over rivers between two cities that do not exist, entire new cities! Locals bristle at any criticism. Everybody tries to shake off the opprobrium of being an emerging market nation. Talk of new paradigms becomes popular – “the Asian century”, “Asian values”.”

“Prices don’t make any rational sense. You only buy because you think you can sell it tomorrow to someone else at a higher price. You are caught in an endless spiral of higher and higher prices. Fear and greed rule financial markets. You are afraid that you might miss out. Your greed is endless. Foreigners develop a peculiar hubris. They are bullet proof. Fundamentals of value are irrelevant in this world.” The Grand Master paused and looked around to see if everybody was paying attention. He leaned back and smiled wryly in a well practised dramatic gesture. “Then, of course, kaput. It all collapses.”

Other seers dispensed more worldly investment wisdom. “If you arrive at a country and discover limousines waiting to transfer foreign investors and their investment bankers to 5 star hotels, then generally speaking it is time to sell. There is a second unfailing test. If you can’t buy a good meal and a young, attractive woman for the night for less than $100, then it is time to get out.”

In July 1997, as the Grand Master had predicted, the Asian boom began to unravel. The Thai Bhat fell sharply. The Thai Central Bank, it turned out, had spent Thailand’s entire foreign currency reserves trying to keep the Bhat within its agreed trading range. It finally conceded defeat and freed the Bhat to float. The HMS Bhat was not seaworthy. It did not “float”. In fact, it seemed to have no visible means of support. It promptly plunged. In a matter of days, it had halved in value. Traders joked about “submerging” rather than “emerging” markets.

Investors belatedly reviewed the value of investments. Glamorous companies, touted as “best-of-breed” world beaters, turned out to have no earnings, no cash flows and no value. Most seemed to be vehicles for property speculation. Investors began to sell. There was only one problem. There were no buyers. The music had stopped. All the seats in this game of musical chairs were firmly occupied.

I would expect that we will start to see a ton of capital to flow out of these countries.  As these central banks scramble to cool off their economies the equity markets have already started to wobble and a ton of supply has recently come into the market as IPO’s have surged in the last year.  With all of the retail money invested in the past 5 years, this will be painful.  In addition, as interest rates rise here, and their currencies weaken against the dollar investing in an emerging market’s debt, yielding 12% in a country with political risk and a currency that is depreciating is no longer attractive.  A 4.5% Treasury or even a 8% corporate is a much safer risk.  While there are problems all across the globe, our worries are that we may be a “has been”, but they are much more likely to be a “never was”.