Some excellent reports on emerging markets and related issues such as inflation here:
Capital-Flows-to-Emerging-Market
The multi trillion dollar issue is how the capital inflow issue is affected by the inflation issue. I suggest emerging market (EM) economies (generally) have more levers at their disposal to deal with inflation than do the highly indebted developed economies. Many em economies adopt positive interest rates with positive trade balances and current account surpluses. Some emerging economies have worked very hard to either acquire or lease commodity production assets in overseas lands. Where this hasn’t been possible long term forward pricing agreements have been made. In addition their economies typically display excess capacity (due to excess investment) and limited debt, as above. In addition, their capital markets are not geared in anything like the same way as the west’s. The rapid double digit growth of many emerging economies in recent years has created inflation. The combinations of capital inflows, rising commodity prices as well as money supply increases through local banking systems have been inflationary but as inflows stalled in Q4 2011, bank lending was curtailed and interest rates turned positive, inflation rapidly diminished again.
Back to the trillion dollar question then. As the global asset price bubble is reflated by the actions of the developed nations central banks from London to New York to Tokyo to Frankfurt where will the inflation show itself? The developed nation currencies look to be in terminal decline and therefore capital flows should once again increase to the emerging world. How will the emerging cope with this additional money supply?
In my opinion we are likely to see the search for yield lead to developed world capital finding itself in emerging markets once again. This will likely elevate asset prices in the emerging world and compress yields of ‘safe’ emerging world assets such as reits in developed capital markets such as HK and SG. Interest rates will have to rise as a response to damped local money supply growth. This could of course, paradoxically, lead to greater capital inflows from the developed world. The compression of yields in the emerging world could be dramatic. In spite of emerging world central bank actions its hard to see a scenario of where inflation will not be felt initially.
In the 1980s developed nations squeezed inflation from the system due to high positive interet rates ie when interest rates became higher than the inflation rate. At the end of the 70s interest rates reached 15% plus in most developed nations. Consumption was sustained in the developed world even as rates went positive as consumer debt, as a proportion of salary, was so low and progressively rose and real salaries out grew inflation.
The developed worlds consumer’s main asset, his house, out performed inflation and hence their balance sheet improved even as debt increased. GDP remained positive therefore even as rates rose above inflation levels.
What can we learn from this? Can we apply what occured in the 70s and 80s in developed nations to emerging nation consumers now? Given the evidence it seems a likely outcome to me. In recent years high positive rates are something the emerging world has got used to given many recent inflationary cycles due to over heated local lending practices and sustained capital inflows. Consumer, corporate and public debt is extremely low on a relative basis comparing emerging markets to developed markets. The old paradigm of risky emerging markets achieving high growth by high non domestic currency leverage has disappeared in most ems. Instead we see ems achieving high growth with low leverage and high savings vs developed market low growth, high leverage and low savings.
We understand all too well how, until 2008, developed markets have enjoyed a 40 year tail wind from increasing public and consumer debt levels. Increasing debt levels and running down savings when real interest rates are negative always seems like an excellent idea. The problem comes when inflation starts to show and rates have to turn positive once again to contain and then erode inflation.
I suggest that the head winds from this history of debt for DMs and tail winds from savings and investment for EMs will soon become more clear to the investment community. Combining this DM high public and consumer debt with a negative DM demographics at a time of a growing world middle class consumer coupled with highly inflationary DM monetary policies is producing a super inflationary environment that will eventually lead to higher interest rates. Who will best survive the coming higher interest rate environment is an excellent question to ask. Commecially speaking, ie using commercial experiences as a reference point, companies that survive best are not the largest or smallest but those that enter the interest rate rising cycle with the least least stressed (debt to cash flow) balancesheets.
Debt to Cash flow, not your Balance Sheet ‘Wealth’, Matters Most in Inflationary Environments..
Applying these commercial principles to governments and consumers we must frame a question as follows. Who will survive higher interest rates best between the indebted, low savings, large balance sheet, developed nation consumer or his lowly leverged, high savings, small balancesheet emerging market rival? As the size of your balance sheet wealth is not relevant when interest rates rise the one DM potential advantage must be removed from the analysis. The key ratio (in a rising interest rate cycle) is the cost of debt servicing to your cash flow. In fact an arguement could be advanced that DM balance sheet wealth could be a mirage that could weaken rather than strengthen DM economies, in a rising interest rate world. If DM consumer and governments alike cannot meet increasingly high interest repays from their cash flow they will try to realize some part of their balancesheet assets for liquidity/cash flow reasons. This attempt to realize their balancesheet wealth is likely to produce forced liquidations in developed markets once interest rates finally rise.
When and if forced liquidations occur in DMs, due to interest rates rises to combat inflation, some asset markets in the west may fall a long long way as capital inflows are unlikely and monetization will be limited by inflation. Therefore, high DM consumer market inflation is very possible alongside asset price deflation as western retiring consumers are forced to realize a part of their balancesheet wealth due to cash flow issues. This process has obvious implications for western banks, note!
On the evidence, in my opinion, it is relatively easy to build a case for why emerging markets may eventually sustain realtively higher growth and real wealth improvements through this coming inflationary wave.
Im sure we will return to this issue again and again.. but out of time for now.
Rich
(5 votes, average: 4.20 out of 5)
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