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Tapering dangers to emerging markets

Nov 02, 2013
Gillian Tett asks very pertinent questions in the FT of November 1, 2013 (Money mirage poses emerging markets danger), “If a shock were 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?


She points out that, “Earlier this year, when investors started to speculate about an American “taper” – or wind-down from quantitative easing – this conjecture was enough to spark a dramatic gyration in the value of some emerging market assets, such as Indian or Brazilian equities.”

Algoam Comment: Here she should have pointed out that this caused the EM currencies to decline in relative value, which has caused,…those markets to have more than recovered.

“The real problems are not to do with growth or capital inflows which could reverse, but with   Illusory liquidity”, she says or the “the market ecosystem around those capital inflows.”

“Now there are fewer – not more – shock absorbers in the markets than before 2008. This factor may explain why this summer’s gyrations in emerging market assets were so dramatic.” she points out.

“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, because of the introduction of the Volcker rule in America which restricts proprietary trading and increases capital charges for banks to hold risky assets,” she highlights.

Algoam Comment: Thus the shock absorbers were the market makers and their inventories, according to Gillian. She doesn’t present any evidence that effects of shocks were less severe. We argue that market makers may actually add to risks (a) because in times of trouble they stop making markets and (b) their own inventories may actually cause even more problems as they dump them into an already evolving chaos. 

Gillian continues, “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 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.”

Algoam Comment:We believe that increased liquidity from uncommitted intermediaries adds to the problems. Liquidity in the wrong hands is a risk for these market makers as well as for end investors. It is not always the end investors who panic first. It is the market makers themselves.

Banks should be prevented from running large positions in the securities they intermediate. Their roles should be simply to bring buyers and sellers together and not take part themselves in the price fixing. 


The article continues, “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 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.”

Algoam Comment: Christine Legarde has the right idea. Replacing market makers with central bankers as Mr. Carney suggests is a poor idea. What works even better is to create incentives for foreign investors to participate in less liquid, or longer term, perhaps direct investment related capital flows and discourage them from excessive speculation by limiting the overall percentage they are allowed to hold. Speculative flows, such a HFT and excess leveraged positions do damage in every economic system and all asset classes.

Gillian’s own solution is, that “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.”

Algoam Comment: This is the best solution. Asset Managers should take risks that they understand, including liquidity risks and take positions that they can manage when and if the markets go into a panic mode. There is no such person as a market maker of last resort.

Gillian says, “There are hints 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 market liquidity looks much deeper. But history shows 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.”

Algoam Comment: Lumbering countries into blocks such as BRICS, Frontier, Baltics etc. was always a stupid idea. Countries have unique risks and each country and its invest-able assets should be looked at in isolation in the context and evolution of those risks. This is true for developed markets as well as emerging markets.

The only redeeming quality for traded risks in blocks is to create liquid instruments for speculators and market makers and that is dangerous for our economic system as more often than not these are the sources of problems not solutions.

Please contact us if you need to have your country risks managed, one country, one currency at a time.