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Wed Aug 24 11:03:55 PDT 2005

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BRAZIL'S ECONOMY
Aug 23rd 2005  

Foreigners are again pouring cash into emerging markets. What will
happen when they stop?

BUTTONWOOD was in the wilds of Guadalajara (Spain's, not Mexico's) last
week, trying to keep teenage bikinis within the bounds of decency, when
the latest twist in Brazil's long-running corruption tale hit the
press. The Spanish have more than a passing interest in Latin America,
even the Portuguese-speaking bits. So coverage of allegations that
Antonio Palocci, Brazil's finance minister, had been on the take in a
previous political incarnation was full and frank. 

The resulting sell-off of the Brazilian market hit assets all around
Latin America. Brazilian bonds have the heaviest weighting in J.P.
Morgan's Emerging Market Bond Index Plus (EMBI+)--the benchmark for
many money managers--and any problem Brazil has makes itself felt. The
spread on the index--ie, the premium that investors demand for holding
an allegedly riskier security than American Treasuries--had fallen from
3.6 percentage points at the beginning of the year to 2.9. On August
19th, it widened back out to 2.95 points. But Mr Palocci effectively
denied the charges over the weekend and appeared to have the confidence
of his president. Brazil bounced back, and by close of play on August
22nd the spread on the EMBI+ was down to 2.92 percentage points.

The speed of the rebound in Brazil is a sign of just how keen investors
are to see the upside in emerging markets. This is borne out by the
latest figures from Emerging Portfolio Fund Research, which tracks
funds with assets totalling more than $4 trillion. Between the
beginning of June and the week ending August 17th, emerging-market
equity funds took in a net $6.94 billion. That brings the year's total
to $8.74 billion, nearly three times 2004's level and more than the
previous high of $8.6 billion for all of 2003. Bond funds tell the same
story, with total net inflows this year of $4.74 billion, a record.

Emerging assets have been making more money for their owners than
developed countries' for a while. The return on emerging-market debt so
far this year has been 5.6%, higher than on Treasuries, for example.
Equities in weird and wonderful places have done better, too: the
Morgan Stanley Capital International index of share prices in emerging
markets is up by almost 13% so far this year, compared with less than
3% for markets in rich countries. Many emerging countries' currencies
are strengthening or expected to do so soon.

All well and good. But Buttonwood had a formative experience when she
moved to Jakarta in 1997 to live the Asian Miracle and caught instead
the Thai baht in freefall, soon followed by the rest of South-East
Asia. And one has to say that the global environment has been
exceptionally kind to emerging markets lately. Interest and inflation
rates are low; demand (in America, parts of Europe and the developing
world) has been strong; commodity prices have been booming; risk
aversion is in retreat. If any of the above stops, or if investors
decide that they have run up emerging-asset prices far enough, will we
see a repeat of the 1997-98 crisis?

In theory, no. Most of the important emerging countries have gone
straight, we are told, and are thus better able to withstand a sharp
reduction in foreign investment than before. Current-account deficits
have been reduced or converted to surpluses. Fiscal policy is more
prudent. Net new borrowing has been limited and the outstanding stock
of debt in most places is dwindling. Inflation has fallen. 

In a study released last week, Christian Stracke of CreditSights, a
research firm, compares emerging economies' dependence on portfolio
inflows now and eight years ago. (Portfolio investment--as opposed to
foreign direct investment--is generally fast and easy to liquidate, and
so includes the sort of "hot money" that travels fast and upsettingly.)
Looking at 25 countries, he finds that dependence is generally much
lower, but patchily so.

As the table shows, portfolio liabilities in the 18 months to June 2005
for the group as a whole were $118.5 billion, far less than the $170.7
billion that came in before June 1997. This averages out some very
different experiences: both Argentina and Brazil have seen liabilities
decrease sharply, while India, Poland and Hungary have had just the
reverse. What is more, the "hotter" sort of portfolio investment--debt
securities--has fallen most (from $116.6 billion to $66.7 billion)
while equity investment has stayed almost the same.

On another measure, the ratio of foreign-exchange reserves to recent
inflows, things look sturdier still. In June 2005, the median emerging
country had enough reserves to cover 529% of the past 18 months'
portfolio inflows, compared with just 222% in June 1997. This average
again masks some big differences: oil-rich Russia's reserves are a
staggering 2,093% of flows, while Turkey has either 161% or 249%,
depending on how one treats the bulky "errors and omissions" category
of its current-account figures.

One can quibble with these figures. Most of the 2005 numbers go up only
to the first quarter, for instance, and portfolio flows picked up
sharply from June. And while it makes sense to look at foreign
portfolio liabilities in isolation--as this is the footloose stuff that
leaves--the parallel existence of foreign portfolio assets is not
totally irrelevant, nor is the size and trend in foreign direct
investment. The broad picture is nonetheless revealing, and, within
limits, encouraging: a sell-off rather than a rout may be the worst
that happens if foreign investors turn tail.

But it would not take much to produce that--higher real interest rates
in America, for a start (and rate rises look likely to continue). The
impact of dearer oil is harder to judge. High oil prices should be a
plus for emerging producers such as Russia and Venezuela, while heavy
importers such as South Korea have enough other attractions to get away
with it. But money managers are beginning to look askance at
emerging-market guzzlers who have subsidised energy use and may no
longer be able to afford it. 

Paradoxically, globalisation may also dim the appeal of emerging
markets by increasing the correlation between developed and developing
assets. Mexico, some say, is beginning to pay the price for its
lockstep with the United States. A sharp increase in risk aversion
would make that matter more: at the moment, investors ask only to be
led to the next frontier, but a few more terrorist attacks in big
financial centres could change that. 

At the end of the day, a bare-knuckled corruption scandal bringing an
important government to its knees--Brazil?--might not be the PASE DE LA
MUERTE that we holidaying hackettes would have seen had we spent more
time at the bullring and less on the beach. But it could well do the
weakening work of the PICADORES.

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Read more Buttonwood columns at www.economist.com/buttonwood[1]

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http://www.economist.com/research/articlesBySubject/display.cfm?id=2512631

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