Abheek Barua: Are safe havens that safe?

The problems in the US credit markets have partly spilled over to other developed markets.

There was a brief period in early June when it seemed that the party in global asset markets was about to come to a somewhat abrupt end. US bond yields shot up on the back of robust labour market data that suggested the possibility of wage-push inflation and policy-rate hikes. Emerging equity markets, particularly in Asia, turned volatile and currencies shed their weight. This stemmed from a fear that hardening bond yields in the US would trigger a flight of capital to conventional "safe havens" like US and European assets.

This proved to be temporary. By the third week of June, Asian stock markets had resumed their northward journey and Asian currencies recovered most of the gains. Commodity prices, which typically display the worst withdrawal symptoms when the dollar gains, remained stubbornly resilient to the dollar's brief rally. Things went back quite literally to square one.

There are a number of factors that explain this resilience of emerging markets, particularly those in Asia, to the vicissitudes of the US. For one, most indicators suggest that Asian economies will continue to register high growth rates without the attendant risk of high inflation. In a recent statement, for example, the Malaysian central bank governor expressed confidence that a 6 per cent growth rate was achievable for this year. Her claim found support in manufacturing sales data. The Philippines' balance of payments numbers turned out to be exceptionally strong, suggesting continued growth momentum. Neither of these economies has incidentally seen a build-up in price pressures. China continues to defy textbooks with searing growth and low inflation. A 9 per cent plus GDP growth rate and sharply moderating inflation have meant that India too has fallen in line with its Asian peers. The high growth and high returns story of these markets remains intact. Thus, investor interest in these markets is unlikely to wane in a hurry.

Besides, there are questions of whether traditional safe havens like the US are that safe anymore. The US economy might not be slipping into recession but there's no denying the fact that rising interest rates and wanton leverage by households have raised serious questions about credit quality. The problems in the US credit markets have partly spilled over to other developed markets.

Also, the jury is still out on how much the slump in the US housing market would impact on the rest of the economy. Speaking at a recent conference held at the Atlanta Federal Reserve, US central bank boss Ben Bernanke seemed to suggest that the impact of the downturn in house prices may linger longer than expected. "Changes in home values may," he pointed out, "affect household borrowing and spending by somewhat more than suggested by the conventional wealth effect". Given these concerns about the US, a switch from relatively stable emerging market equities to US assets hardly seems like a "flight to quality".

Then there is the yen factor. The yen has remained weak against the dollar and interest rates have remained low. Given these, "carry trades" have returned with a vengeance. Investors are borrowing in yen at low rates and have bought high-yield assets across markets. I suspect that quite a large fraction of this money has actually flowed into Asian emerging markets. The fact that the yen hasn't appreciated against other currencies means that investors haven't lost on the exchange rate when they have converted their gains back into the yen and paid off their loans. The biggest beneficiaries have, of course, been Japanese households. The funny thing is that the Japanese policymakers have not been particularly bothered by this proliferation of "carry trade". Their rationale is perhaps that the wealth effect that results would buttress domestic demand and help in reviving the Japanese economy.

There are two likely scenarios that could pan out going forward. Asian emerging markets could continue to remain rock-solid and the ramifications of periodic upheavals in the US bond markets could remain US-centric. At worst, the effects of a shock in US fixed-income markets could spread to fixed-income assets in a couple of other developed markets. The other extreme scenario, of course, is that the events of early June were rumbles of distant thunder""a warning signal that if inflationary pressures in the US intensify and bond yields rise further, they could lead to a significant reallocation of funds across markets. If indeed, money starts moving back to the US and developed European markets, Asian equities and currencies could take a bath.

At this stage, I am most comfortable sitting on the fence. My sense is that US bond yields could rise a little more and while a huge shakeout in Asian markets is unlikely, they could enter a phase of "consolidation" (the fence-sitter's favourite word, incidentally). Thus these markets might not lose much from these levels but are unlikely to gain significantly, either. It is also likely that some of the currencies including the rupee might depreciate a little in the coming months.

Let me end by pointing out two sets of risks that could poop the emerging asset markets party. The first is the fact that a large bit of the funds comes from just one currency, the yen. Were the Japanese authorities to become more alert to the perils of carry trade, fund flows can take a hit. The second risk is of escalating oil prices that would tend to nudge headline inflation up. If central banks were to respond actively, it could compromise growth prospects in emerging markets. The current problems notwithstanding, if the US bonds do offer returns that are high enough, there could be a revival of flows back into the US. Both could lead to a de-rating of emerging markets.