Emerging theory

Will higher US interest rates have the same effect on emerging markets as in 1994?

Forget the elections. Forget the corporate results. The eyes of investors around the world are glued to every move of Federal Reserve Chairman Alan Greenspan, looking for signals on what he'll do to US interest rates.

Why are US interest rates so important? Well, in March 1994, when the US Federal Reserve signalled an about turn in monetary policy and switched to tightening mode, there was an immediate 10.1 per cent decline in the IFCI Emerging Markets index, which is the global index for emerging markets.

The index wilted further as the US Fed continued to increase US interest rates, the cumulative drop in the index being 29.1 per cent between September 1994 and March 1995. The index fell 10.3 per cent in calendar 1995.

That pullback, point out market watchers, is closely linked to the rise in the Federal funds rate from 3 per cent to 6 per cent during 1994-95.

Ten years later, many observers say that the conditions in the bond and stock markets are similar to 1994.

The International Monetary Fund's Global Financial Stability Report for April 2004 points to the similarities: 1) the increase in short-term interest rates priced into futures markets at the beginning of 2004 was broadly comparable to the increase priced in a decade ago for shorter-dated contracts. For longer-dated contracts, the magnitudes of interest rate increases expected at the beginning of 2004 exceed those of 1994; 2) the US treasury yield curve in 1994 and the beginning of 2004 was exceedingly steep; 3) the curve's steepness is an incentive for carry trades, where traders borrow at short-term rates and build up positions at the long end. Putting it simply, markets are more leveraged than in 1994; 4)there's a marked compression of corporate credit spreads in 2004, as was the case in 1994.

At the same time, the IMF also points to the dissimilarities between 1994 and 2004. These are: 1) real interest rates are far lower than they were in 1994; 2) inflationary pressures are far more subdued in 2004 compared to 10 years ago, thanks to high productivity, softness in the labour market and low capacity utilisation.

In spite of these mitigating factors, the IMF has warned the US Fed to prepare the world for a rise in US interest rates""some are forecasting a rise as early as August.

Among the risk factors the IMF is too polite to harp on""the record US fiscal deficit, the imbalance in its current account deficit, and the flood of money pushing up the world's stock markets. Simply put, when monetary policy in the US tightens, what'll happen to markets addicted to their daily fix of foreign inflows?

Not everyone subscribes to the 1994 apocalyptic scenario. The Institute of International Finance says that portfolio equity investment to emerging markets, which surged to more than $27 billion in 2003, the highest in seven years, is expected to move up to $33 billion this year, with Asia expected to account for 95 per cent of all emerging market flows.

The IIF expects portfolio flows to India this year at $7 billion, less than last year, but still substantial. Others point out that interest rates are so low in the US that a small tightening will not really hurt equity markets in emerging markets""in other words, even if interest rates go up by 50 basis points in the US, yields will be so low that investors will continue to be search for higher returns.

The worry is that if the US economy roars back, funds may switch back to US equities. Others say that one of the reasons for the 1994 debacle was the Mexican Tequila effect, when Mexico was close to default on its debt. That is true, but the Asian IFCI index too fell 7 per cent in 1995.

The record shows that the net FII flows to India fell sharply in mid-1994 and continued to be low in 1995. The Sensex, which had moved up smartly in 1993-94, fell from around the 4200 levels in March 1994 to around 3600 in February 1995 and, thereafter, to around 3000 by December 1995.

A paper on portfolio flows into India by James Gordon and Poonam Gupta for presentation at NCAER in October 2002 concluded that the key variables influencing FII flows are "external interest rate and lagged domestic stock market return."

Market watchers have for long preached the virtues of investment in emerging markets as a source of portfolio diversification for US and other developed world investors.

But, contrary to theory, emerging markets have always reacted to changes in developed countries. Will markets such as India and China be able to attract funds on their own domestic strengths? We won't have to wait very long to find out.