I’m worried, for example, that Solvency II, which assumes incorrectly that Eurozone sovereign bonds are safe, and penalises investment in less risky and diversifying investments like emerging sovereign debt, will be applied to pension funds. It would constitute financial repression should institutional savings be forced to invest where governments wants help for a crippled financial system.
Behind the current regulatory drift is a mistaken conception of risk that assumes an ascending risk scale from US and European government bonds upwards. Insurers
The second thing that worries me is that regulators will make mistakes in extreme environments which will increase uncertainty and reduce trust in policy stability. For example, European leaders may decide to use regulators and taxes to incentivise non-economically advantageous bond swaps on their domestic investors, in place of a formal haircut. Worse, though not likely, in order to bail-in foreign holders not so easy to control directly, there could be capital controls.
What the developed world is teaching the developing world is that our model is faulty. There are some simple principles about how to regulate banks, which we forgot: keep it simple; regulate thoroughly and know where the pools of liquidity are.
Indeed, I think emerging markets have something to teach the developed world about regulation; they have practical experience of these problems. I’ve been in meetings with central banks where it is the emerging market representatives who are giving the practical advice.
If you’re in a dark alley late at night and there are some thugs up ahead, you want someone with you who has been in a few scraps. Because emerging markets have recent memories of balance of payments problems and financial crises, they have not become complacent.
Historically we knew how to regulate in the UK but that didn’t stop the response to Northern Rock being painfully slow. Academic research shows that financial crises are no less likely in developed countries.
Brazil is a good example of an emerging economy with effective regulatory oversight. It is a complex market but the central bank has an accurate overall picture of where all the liquidity pools are throughout the system and therefore understands which areas need to be regulated.
One learns by mistakes. In emerging markets, one of the most dramatic examples might be provided by Russia in 1998, when Prime Minister Sergey Kiriyenko chose to default on domestic debt at the same time as devaluing the rouble and issuing a moratorium on debt payments owed beyond Russia.
The rapid growth of ETFs is a worry because they are not necessarily a safe way to invest. For example, an economy heavily indebted because of poor economic policy will be a big part of a capitalisation-weighted index.
Prior to its default, Argentina comprised 25% of one emerging debt index: not because its economy was huge but because it was so profligate. Anyone who failed to predict its high default risk in 2001 should not really be managing other people’s money in my view – it was a very easy call.
As a result, the vast majority of managers held very little of their debt. The only people who held 25% of the debt were the index investors. The first role of an active manager is to reduce risk. This exposes the lie of the term benchmark risk which misleadingly implies deviation from a benchmark constitutes risk.
So the most risky way to invest in emerging markets is arguably through passive benchmarks. ETFs are consequently a fad which may pass.
In general, the crisis is good news for emerging markets because it challenges intellectually bankrupt conceptions of risk. Consider the money markets in the emerging world, valued at around $9tn. Money markets don’t normally figure much in asset allocations as (the trade-off for low risk) they are assumed not to yield much – not so though in emerging markets.
Emerging markets are also winners from the crisis. Theirs are now the biggest global banks; they are becoming price makers in more and more goods markets, not just commodities.
In ten or twenty years when people retire, perhaps half of everything they buy will be manufactured and priced in emerging markets. So, fundamentally they are part of everyone’s liability structure today. Not to be invested in them thus constitutes imprudence fortified by prejudice.