Emerging markets hit by signs US Fed will close cash tap

PARIS - Investors have begun pulling money out of emerging economies mainly because they think that the US Federal Reserve central bank may be about to wind down its easy-money policy which has supported the economy and pushed funds into the financial system.

This prospect has reduced the willingness of fund managers to take risks even though only a few months ago their focus was more on a rapid rise of stock markets and signs that maybe assets prices were overheating.

At HSBC Global Asset Management France, the head of personal portfolio investment Olivier Gayno said that stock markets in emerging economies had fallen "by more than five per cent in a month." On Thursday, stock markets in Asia fell heavily, with prices in Manilla, Bangkok and Jakarta following a plunge of 6.35 per cent on the Tokyo market.

European stocks opened with falls of 1.0-1.5 per cent.

The main cause is in the form of signals from the US central bank that it is likely to begin turning off the tap which has kept huge amounts of new money flowing into the US financial system each month as part of exceptional measures to help the economy to pull away from five years of crisis and weak growth.

This policy bolstered confidence which in turn reversed a reluctance of investors to take risk: instead they began switching funds into assets offering higher returns than government bonds, and in particular to emerging markets which have been achieving relatively strong growth.

This trend was so strong that the International Monetary Fund warned that the inflow of funds could cause overheating of in emerging economies.

But now investors are on the retreat and some of their investment funding is flowing out of these regions.

Indonesian Finance Minister Chatib Basri explained that three factors lay behind this "global phenomenon": the progressive reduction of Federal Reserve's programme to buy assets thereby injecting cash, a decision by the Bank of Japan at the beginning of the week not to ramp up its easy-money policy, and the attitude of the European Central Bank which reduced its key rates in May but not in June.

The retreat from risk is affecting a range of assets in addition to stocks.

"All asset classes in emerging countries have suffered,", commented AXA IM strategist Mathieu L'Hoir.

The biggest effect has been on government debt markets: bonds priced in terms of local currency had fallen by 8.0 per cent in value in a month, he said.

The consequence of this is that the interest rate which some emerging countries must pay to borrow on the bond market has risen sharply.

This is because bonds are issued with a fixed interest rate for the life of the loan. If perceived risk rises, and investors sell bonds, the price of the bonds falls, and the fixed interest rises automatically relative to the new price. This sets the interest rate which investors will demand at the next bond auction.

Among countries caught by rising bond rates are Brazil, South Africa and Turkey, although Turkey is also under pressure from civil unrest.

At Capital Economics in London, analyst William Jackson said: "Turkey's dependence on foreign capital makes it one of the most vulnerable emerging markets to a deterioration in investor sentiment."

Forex pressures

L'Hoir said that the flow of funds in search of higher returns from assets had "had the effect of creating bubbles", meaning that the price of bonds issued by states had been too high and the fixed interest attached to them had been too low.

The fall of bond prices now was therefore a process of "normalisation", he said, but this was generating some "turbulence." The trend for some investment funding to flow out of emerging economies is affecting foreign exchange rates.

The South African rand has fallen by 7.0 per cent in a month and the Brazilian real by 10.0 per cent, AXA IM said.

The Bank of Indonesia has had to support its currency when it fell to the lowest level for four years. The authorities in Brazil and India have also taken steps to support their local money.

These price changes could eventually have an effect on economic activity in some countries which depend heavily on inflows of capital to finance investment and business.

But some experts hold that the change of direction of the investment flows could have a positive side. Thai Finance Minister Kittiratt Na-Ranong said that it was good to move away from overheating and allow the economy to find its balance.

His government did not intend to take immediate measures to slow down the outflow of capital or to support share prices, he said.

Capital Economics analyst Michael Henderson said: "Most emerging markets are likely to tolerate the recent sell-off in their currencies. But there are a few exceptions.

"Inflation concerns mean that currency weakness will put policymakers under pressure in Brazil and India, while heavy foreign exchange burdens imply that policymakers in emerging Europe could be forced to take additional steps to support their currencies."