Thursday, October 16, 2008

The Debts of the Lenders: Bears Engulf Emerging Markets

After making a fortune shorting financials, the bears are now targetting entire countries' economies. This is reflected in the CDS costs of US and European banks that have narrowed while sovereign default insurance has ballooned. Of course the possibility of a major European and/or US collapse are distant at this point. The real money is in shorting the emerging market indices.

Brazil, Russia, Mexico, India, Indonesia, and S. Korea have suffered heavily in the past 3 weeks. I am not sure what their CDS costs are but they should be pretty high. In any event, there is more solid evidence of their instability - daily circuit breakers being applied (mkts temporarily shut down), short selling bans, strict capital controls, and other signs of panic.

Although insulated from the worst excesses of the credit bubble storm that has wracked the developed world, developing nations are now facing sharply falling demand for their goods as consumers tighten their belts. Many- if not most - emerging markets are one trick ponies; good only for a particular export or raw material sector.

For ex: Brazil's Bovespa is dominated by agriculture and mining, Russia's by oil and natural gas; and the East Asian economies by cheap manufactured goods. Moreover, credit problems in the West are exacerbating importers' problems in securing short term credit...even in the face of slumping freight costs.

Mutual fund redemptions are hurting the emerging market indices as the flow of funds from account holders reverts back to the US. Fund managers are liquidating the higher priced foreign stocks and triggering further sell-offs in lower trading stocks.

Finally, emerging market economies remain vulnerable due to their debt exposure to foreign currencies. Unlike the EU and the USA, most emerging markets do NOT have the luxury of having their debt denominated in their native currencies. They are unable to adopt the
sweeping corporate welfare programs that the US and EU have adopted due to fears of higher inflation. Government ministers imported inflation through monetary and fiscal ties such as currency pegs to grow their export engines. While inflation was a necessary evil during the expansionary boom times, it has the potential to become a greater demon within the borders of emerging markets. Countries such as Russia, Iran, and Venezuela already have to contend with double digit rates of inflation (15-40% according to which source you believe).


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