As a result, we have seen strong capital inflows to emerging markets resulting from global asset reallocation by institutional investors. 

There is scope for additional sizeable asset reallocation to emerging markets, which could be overwhelming in some cases. Institutional investors worldwide have not yet adopted a global approach in their equity allocation process.  US investors heavily underweight non-US equities.  The reallocation of a small portion of financial assets of advanced countries could have very large effects on emerging market countries.  A one percentage point reallocation of global equity and debt securities held by G-4 investors would result in additional portfolio flows of $485 billion.  Countries receiving a large share of these flows relative to the size of their markets could face significant challenges. IMF research suggests that the combination of large capital inflows and accommodative monetary policy raises the risk of asset-price boom-bust cycles. Investor flow data suggests emerging markets tend to suffer from herding behaviour.  There is evidence of a self-reinforcing cycle between inflows and returns.

There are various macroeconomic policies that can be deployed to address the effects of capital inflows, including exchange rate appreciation, reserve accumulation, and tighter fiscal policy.  Brazil has chosen to reimpose a two percent upfront tax on capital inflows in October 2009 to limit exchange rate appreciation.  These capital controls had a small but discernable impact on interest rate arbitrage. However, they do not appear to have reduced aggregate capital flows into Brazil.  After this IOF was imposed, the nominal appreciation against the dollar came to an end, but reserves continued to rise steadily and the Real continued to appreciate against the Euro.

While publicly listed securities in emerging markets do not appear overpriced as yet, given the favourable risk-adjusted rate of return outlook, there is clearly a base forming for a potential bubble. I have been advocating for years that portfolios should have a large exposure to emerging markets, but this exposure should not consist exclusively of publicly traded securities. They should account for five percent of the total portfolio, to be increased to ten percent whenever there is a pullback in these markets. Secondly, the portfolio should have a five percent exposure to infrastructure loans and other loans that enjoy the umbrella protection of IFIs. Thirdly, the portfolio should have a ten percent equity exposure to world class blue chip companies that derive a large and growing portion of their revenue from emerging markets, such as Unilever, Proctor & Gamble, Caterpillar, Nestlé, Johnson & Johnson and Novartis to mention–but not recommend–just a few examples.

Institutional investors will have to rethink their approach to emerging markets and restructure themselves accordingly.  Emerging and frontier markets should not be a small and speculative sideshow, but should form a major portion of the portfolio, encompassing all asset classes like public debt and equity, private loans and infrastructure debt, private equity and real estate. In order to do justice to these asset classes in developing countries, the institutional investor has to re-staff and retrain the investment department and has to form close alliances with experienced and trustworthy emerging market experts.  This is a daunting task which will take years to implement.

October 2010

 

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