THE INSIDERS: Emerging Markets In An Upside Down World

By bne IntelliNews March 26, 2014

Dr Jerome Booth of New Sparta Limited -

In 2011, I wrote the following about Dead Bodies.

The UK has its dead body on the kitchen floor, blood everywhere. We are trying to clear up the mess: we can see a policy route to macro-economic stability and sustainable debt levels that is painful but realistic.

In the Eurozone the dead body is not quite as large as in the UK and is around the edge of the room (the Dutch and German parts of the floor are clean). The policy response is akin to covering the body with a sheet and agreeing to deal with it later. Denial is palpable, but the blood is unfortunately spilling out under the sheet and starting to damage Eurozone shoe leather - even threatening a nasty stain on Germany's clean part of the floor. At one level this is not too worrying for Germany, as they have plenty of floor cleaning equipment, but they didn't reckon on cleaning everybody else's part of the floor as well. If they are expected to do that, they need some new rules established. These need to change the antisocial habits (fiscal profligacy, lying about one's numbers) that caused the current (preventable) deaths. And the same old promises to be more careful next time are not good enough. The result is a lot of bickering. The outcome so far has been to come up with larger sheets, without much cleaning up going on. Even with the latest bailout, which buys time, Greece's debt/GDP is unsustainable under any credible fiscal outcomes without major debt reduction.

However, in the US denial is even more pronounced: the cadaver has been placed in a chair, given a cup of coffee and is being engaged in conversation. The US is assumed by many to be zero risk or "risk free" even when evidence of severe macro-economic vulnerabilities is plain. In the US especially, there are many who think de-leveraging and the pain it involves can somehow be avoided. It cannot, and the denial merely allows the problems to fester.

Since writing the above, there has been some progress in the EU - including the recent agreement on banking union - but denial is still strong, reaction slow and policy inward looking. The EU and US - the HIDCs (Heavily Indebted Developed Countries) as I call them - suffer not only from very high debt levels which will take years to fix, but from Core/Periphery disease. This is the deep-seated meme that the core (the developed world) affects the Periphery (the emerging world), but that we can ignore the impact of the Periphery on the Core. That the Core is in hock to the emerging markets who own 80% of global central bank reserves is ignored.

Commentators and investors belittle these macro-economic imbalances and the risks they pose. In part this is due to intellectual failure in finance and economics. Prejudice about the shape of the (investment) world has caused major distortions in the global allocation of capital, including bizarrely large flows from emerging countries to the HIDCs. For example, if all currencies (developed and emerging) are not only volatile against the dollar but also highly correlated, then we think risk is all over the place and retreat to the perceived safety of the US. But we might instead conclude that it's the dollar which is volatile. We say US Treasury bonds are "risk-free", which is an abuse of the English language.

A move to historical average yields could wipe out a quarter of their value and more could easily be lost through devaluation and inflation. The last time there were major imbalances in the international monetary system and Nixon came off convertibility to gold in 1971, the dollar fell from $35 an ounce to around $195 an ounce by 1974.

Losses are coming

Large HIDC debts are not going to be eroded by economic growth alone, but through negative real interest rates - be it via financial repression or inflation. That is the historical record post- WWII and in the 1970s. We know from behavioural finance that people don't mind being robbed slowly, especially if its other people's money, but losses are coming for those foolhardy enough to buy and hold HIDC sovereign debt.

Such denial is no joking matter and is the tip of the iceberg of faulty thinking when it comes to investing as well as financial and economic policymaking. Denial, hubris and hypocrisy have been in evidence from the West concerning Crimea recently, but they are nothing new, and not restricted to foreign policy.

So I have written a book, "Emerging Markets in an Upside Down World". Or rather it is several books. I found it necessary to weave different threads together in order to lead the reader to my thinking on why asset allocation today is so massively distorted.

I start with a chapter on globalisation and then a history of emerging markets, most especially emerging debt markets. I have never found a satisfactory history of this elsewhere. Giving such a huge topic a single chapter rather than a whole book, I have necessarily focused on parts I think particularly relevant for investors and policymakers today. But I do include some broad points about the role of debt in politics historically and how it can improve governance. I also chart some of the twists and turns in the last couple of decades between markets and policy-makers in the (at times painful but also glorious) birth of modern emerging capital markets.

After a chapter on my view of what when wrong in 2008 in the HIDCs comes the destruction job on finance theory. Just as 80% of Keynes' General Theory is a demolition job on the status quo in order to clear the way for his new invention - macroeconomics - so I at more modest scale provide a critique of finance theory; and especially the concept of risk, which gets a whole chapter just to itself.

After a chapter on Core/Periphery disease, I focus on the structure of investor bases, which affects liquidity, risk and much else. This is followed by chapters of how asset allocation is currently done, how we should think more strategically, and then a check list for the investor.

So the book is an emerging market history, a critique of finance theory, a practical guide for the investor, but also - in the last major chapter - a guide for policymakers. I hope the book will be read by investors everywhere (including those not interested in emerging markets); by students of finance theory, economics, business and emerging markets; and by policymakers. I have avoided equations and made the book accessible to the interested lay reader.

So enjoy!

"Emerging Markets in an Upside Down World", published by John Wiley & Sons, is available

in hardback here.

THE INSIDERS: Emerging Markets In An Upside Down World

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