Positive Discrimination
Mar 16, 2006
Serhan Cevik (from Copenhagen)
The normalisation of ultra-loose monetary conditions pressurises global capital markets. Unsurprising measures of monetary tightening introduced by the central banks of industrialised countries to ensure price and financial stability have incidentally triggered a new wave of sell-off in financial markets and capital outflow from emerging markets. Even though we welcome efforts to address global imbalances and to achieve sustainable economic growth, the adjustment phase could be long and painful in a world that has become accustomed to unusually low real interest rates and abundant liquidity. Furthermore, the ongoing shifts in global portfolio allocations result in increasing volatility across asset classes, and thereby may well lead to further reduction in risk appetite. However, we need to be careful about generalising about the implications of greater risk aversion and extrapolating recent oscillations in global capital markets. In our view, investors should focus less on speculative, liquidity-driven investment opportunities and more on assets supported by solid economic fundamentals and institutional progress that reduces the risk of political discontinuity.
Ultra-low interest rates and petro-dollar liquidity have created asset bubbles in shallow markets. In the last five years, we have witnessed numerous ‘asset bubbles’ emerging one after another all around the world — some justified by improvements in economic fundamentals, but some simply a by-product of super-low real interest rates in developed countries. The latest cycle, compared with previous episodes of financial enthusiasm, has also been fuelled by one more factor: petro-dollar liquidity. The recycling of export earnings from fossil-fuel and other commodities into financial markets has certainly brought benefits to developing countries, but has also led to ballooning asset prices, particularly in the shallow markets of the Middle East and North Africa region. Even countries with low quality of governance, wide-ranging structural problems and inappropriate policies have become ‘the next big thing’ in the global search for higher returns. And now this indiscriminative approach, once heralded as cutting-edge, has suddenly turned into an appalling liability. However, mood swings moving from one extreme to another, though challenging, create new investment prospects, in our view. The strength of fundamentals will determine the next stage of convergence in emerging markets, in our view. Institutional as well as retail investors ultimately care about financial performance relative to holding ‘risk-free’ assets. In difficult times, with lowering risk appetite, we may see indiscriminative assessment of all ‘riskier’ assets. Nevertheless, once the initial shock starts to disappear, the strength of economic and financial fundamentals should become the key factor determining the attractiveness of asset classes and therefore the next stage of nominal and real convergence in emerging markets. At such a juncture, we believe that countries with an unambiguous track-record of prudent policymaking and structural reforms will outshine those with a disappointing history of fiscal and monetary management. The Middle East and North Africa region offers striking cases in point. Take, for example, Egypt and Turkey. Without notable structural adjustments and disciplined policymaking, the Egyptian economy has enjoyed, thanks to petro-dollar liquidity, accelerating output growth and a skyrocketing equity market that outperformed almost all the others, including the Istanbul Stock Exchange. But that is now history and should have almost no bearing on Egypt’s performance in the future. Turkey, on the other hand, while benefiting from favourable liquidity conditions, has undertaken rigorous fiscal correction and introduced far-reaching structural reforms. Prudent fiscal and monetary policies are the best insurance against exogenous shocks, in our view. The Egyptian authorities have long failed to take advantage of the liquidity-driven reduction in volatility and, as a result, now face a challenging outlook. Because of populist decisions, the government budget deficit has widened to an unsustainable level of over 10% of GDP, increasing the public-sector debt stock from 75.4% of GDP in 2000 to 112% last year. Moreover, given the shallow depth of the country’s financial system, the Central Bank of Egypt has become the most important source of funding for ever-increasing budgetary expenditures and, as a result, now carries a stock of government debt worth more than 50% of GDP (see Egypt: The Burden of Fiscal Dominance, October 12, 2005). We fear that Egypt’s growing fiscal imbalances and the central bank’s accommodative monetary policy stance are an open invitation to costly shocks, particularly in an investment climate shaped by tighter monetary conditions. Turkey, firmly on the other opposite end of the adjustment spectrum, has undertaken significant fiscal correction by maintaining an average primary budget surplus of 6.1% of GDP in the past six years, lowering the public-sector borrowing requirement and net public-sector debt, as a share of GDP, from 16.5% and 90.5%, respectively, to 0.8% in 2001 and 56.5% last year (see Turkey: The Case for Investment Grade, February 13, 2006). In our view, prudent fiscal and monetary policies, especially in countries with imperfect institutional credibility, offer the best insurance policy against ‘unexpected’ shocks originating in global markets. Therefore, positive discrimination in an increasingly risk-averse investment environment is likely to favour countries clearly committed to sound policies and to dealing with underlying weaknesses.
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