Call for caution

Call for caution

Rob Morrison, head of CLSA Asia-Pacific Markets, who told Mint on Wednesday that an asset bubble is forming in Asian markets, has company. An increasing number of fund managers and market strategists are convinced likewise.

When the subprime and credit crises first hit the markets in late July, the concern was that its effects would spill over into all financial markets and assets. That concern was not without a basis. The driving force of the bull run of the last four years had been cheap credit and liquidity and the worry was that the credit crunch would force banks to tighten their purse strings, forcing the markets to correct.

But those who argued in this fashion failed to gauge the extent of liquidity in the global economy. High oil prices have led to large surpluses in West Asia, while the burgeoning foreign exchange reserves of the Asian economies have been another source of liquidity. Some observers predicted that because of the problems affecting the mortgage and mortgage derivative markets in the developed markets, the funds invested in these would move to other asset classes, including equities. That’s precisely what happened. As the credit markets of the West went into a gridlock, fund managers searched for havens unaffected by the credit contagion that could also deliver superior returns. Emerging market equities were an obvious choice and, within them, large, high-growth economies such as India and China.

The process got a big push by the US Federal Reserve’s 50 basis point rate cut in September—a pleasant surprise for the market. The signal the Fed gave out was unmistakable: it stood ready to provide liquidity to the markets whenever needed. This also hastened the fall of the dollar.

With continuing uncertainty about the extent of the losses that banks in the developed markets would face and worries that the US housing slump would exacerbate, the additional liquidity immediately flooded into emerging market equities on the one hand and commodities on the other. The markets reasoned that if the US Fed was committed to lowering rates, the dollar would continue to fall, and non-dollar assets became even more attractive. This was particularly true of countries, such as India, where the central bank allowed the local currency to appreciate.

Small wonder that a tidal wave of dollars flooded the Indian market immediately after the announcement of the Fed rate cut in September. An analysis of global fund flows shows that the money flowing into emerging markets is coming out of redemptions from the US and Europe funds.

Observers say this is the Asian crisis in reverse. During that crisis, money fleeing Asia went back to the US. And the extra liquidity, compounded by rate cuts by the US Fed— which was trying to counter the impact of the implosion of hedge fund Long-Term Capital Management—sent the US markets to new highs.

The big theme of that bubble was tech stocks and the Nasdaq rose to dizzying heights. This time, the money is flowing back to emerging markets and, as it’s the nature of markets to overshoot, a bubble is a very likely outcome. But unlike the Nasdaq bubble, emerging markets do not have dot-coms as their base. They have very strong economies and robust growth.

The risk is that unwary retail investors will get in at the very top and get caught when the bubble bursts. That’s what happened to many investors during the Nasdaq bubble and the Asian crisis, and before that when the Nikkei crashed. It is also what seems to be happening in China.

This is the time for the market regulator and the central bank to be proactive and to nip irrational exuberance in the bud—and for investors to be extra cautious. From that perspective,?the restrictions on participatory notes couldn’t have come at a better time.

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