If a shock was to hit Brazil, India, Indonesia – or any other emerging market country – tomorrow, how would investors react? Would asset values adjust smoothly, amid an explosion of trading flows? Or would markets instead freeze up, as liquidity evaporated?
It is not an academic question. Earlier this year, when investors started to speculate about an American “taper” – or wind-down from quantitative easing – this mere conjecture was enough to spark a dramatic gyration in the value of some emerging market assets, such as Indian or Brazilian equities.
Since then, those markets have more than recovered. And with most economists still believing the taper remains many months away, investors expect this rally to continue. But behind the scenes, as the private debates in October’s meeting of the International Monetary Fund indicated, some policy makers and asset managers are getting uneasy.
For the real problem with emerging markets today, policy makers admit, is not simply that reform has slowed in places such as Brazil, or that growth rates have disappointed since the 2008 crisis. Nor is it simply that some emerging market countries have experienced spectacular capital inflows – and could thus suffer economic pain if these reverse.
Instead the third, often ignored, issue is the market ecosystem around those capital inflows. Most notably, as money has rushed into emerging markets in recent years, this has created an image of abundant liquidity. But this image may be dangerously illusory, some policy makers fear, as one of the little-noticed ironies of the 2013 financial system is that there may now be fewer – not more – shock absorbers in the markets than there were before 2008. This factor may explain why this summer’s gyrations in emerging market assets were so dramatic.
The key issue at stake, as Mark Carney, Bank of England governor, indicated in a speech last week, is the question of who makes markets in a crisis. Before 2007, when the investment banking world was expanding at a breathless pace, dealers held large stocks of emerging market assets on their books. But since 2008 these inventories have shrunk more than 70 per cent, according to central bank estimates, due to the introduction of the Volcker rule in America (which restricts proprietary trading) and increases capital charges for banks to hold risky assets.
This has undermined the ability of dealers to supply trading liquidity in some asset classes. Take emerging market debt. JPMorgan estimates that since 2008 investors have gobbled up more than $315bn worth of securities. But it also estimates that dealers now hold a mere 0.5 per cent of outstanding stock, or less than one day’s worth of trading volumes. This means they cannot provide much trading “lubricant” if a crisis hits. And just to add to the problem, liquidity levels in emerging markets are already extremely uneven, with the vast majority of trading currently concentrated in a few markets such as Mexico and Korea.
So is there any solution? One option, some bankers mutter, would be to roll back some of the post-2008 financial reforms in relation to, say, banks’ trading books. However, this seems most unlikely to happen given that regulators want to reduce the riskiness of banks. So policy makers are now hunting for alternative ideas. At October’s IMF meeting, for example, Christine Lagarde, IMF head, called on emerging market countries to accelerate reforms to make their capital markets more mature. And last week Mr Carney floated a more radical idea: he suggested that central banks should adopt new measures to ensure liquidity is maintained in a crisis, by overhauling the way that collateral is used by banks.
But though Mr Carney’s intervention reveals the level of unease about this issue – not just in relation to emerging market assets but many other securities too – his policy ideas are still at an embryonic stage. Neither they, nor the IMF appeals, will offer any solution soon. Thus for the moment the only practical answer is a fourth “solution”: asset managers themselves need to start paying more attention to the underlying liquidity issues, and pricing assets accordingly for a world without any market maker of last resort.
There are hints that this is now happening. This autumn, some asset managers are no longer blindly enthusing about the “BRICs” as a single asset class; instead, they are shunning the “BIITS” (Brazil, India, Indonesia, Turkey and South Africa) to focus on markets where there are fewer structural challenges and where the market liquidity looks much deeper. But history shows that memories about liquidity risk tend to be short; particularly when so much easy money is flooding around. Or to put it another way, even if the Fed now delays that “taper”, investors should not forget this summer’s gyrations. It was a potent warning shot, on many different levels.
Gillian Tett
Fonte: FT
