[A-List] More bubbles in the works

["Sabri Oncu" <soncu@xxxxxxxxxxx>]

Funds Blowing Foreign Bubbles?

By Paul Blustein
Washington Post Staff Writer
Thursday, December 8, 2005; D01

Remember the financial crisis that laid waste to the Mexican economy in
1995? Or Thailand's meltdown in 1997, which soon spread to Indonesia, South
Korea, the Philippines, Russia and Brazil? Or the implosion of Argentina's
economy in 2001, which left millions of people destitute?

Just distant memories, unlikely to recur -- or so the world's investors seem
to have concluded.

International money managers are pouring funds at a record pace into the
emerging markets of Latin America, Asia, Eastern Europe and Africa. Cash is
gushing into mutual funds that specialize in emerging markets, and billions
of dollars more are flowing into such countries from giant insurance
companies and pension funds.

Turkey's stock market is up more than 50 percent this year; Mexico's is up
more than 30 percent; Egyptian stocks have more than doubled. And investors
are snapping up bonds issued by emerging-market governments with remarkable
gusto.

Therein lie the makings of future disasters, in the view of many economists,
market veterans and policymakers. Having pumped large sums into emerging
markets at a time of low interest rates and high prices for the commodities
that many developing countries produce, investors may well bolt when
conditions deteriorate, with the sudden outflow of cash devastating
economies and plunging governments into default.

"I worry that there's this perfect storm coming for emerging markets," said
Kristin J. Forbes, a Massachusetts Institute of Technology economics
professor who served until early this year on President Bush's Council of
Economic Advisers.

To hear professional investors tell it, their current bullishness is based
on the vastly more prudent economic policies that emerging-market nations
have adopted. They cite the higher ratings bestowed by credit agencies such
as Moody's and Standard & Poor's on countries that only a few years ago were
plagued by defaults and currency devaluations. For example, government bonds
issued by Mexico, Russia and Poland now qualify as "investment grade."

"Those ratings have come from fundamental improvements in monetary and
fiscal policy," said Dario Pedrajo, senior portfolio manager at Biscayne
Americas Advisors. "Deficit spending has declined considerably in
emerging-market countries."

But skeptics contend that the main reason for the boom is the paltry level
of interest rates in the United States, Europe and Japan, which prompts
money managers flush with cash to scour the globe for investments providing
at least slightly better returns. "There's just a huge amount of money
sloshing around looking for a place to go," said Desmond Lachman, an
economist at the American Enterprise Institute who, as a Wall Street
research analyst, was one of the first to predict doom for Argentina well
before its 2001 default.

The problem, Lachman and others said, is that the influx of cash makes the
financial strength of many countries look better than it really is -- and
deludes government officials into believing that their policies must be
near-perfect. "Even Turkeys Fly When the Winds Are Strong" is how Lachman
put it in the title of an article he published recently in the magazine
International Economy.

Alarming or heartening, the amount of private capital flowing into emerging
markets is reaching all-time highs -- a total of $345 billion this year,
according to a September estimate from the Institute of International
Finance, an organization of multinational banks, securities firms and other
financial institutions. Drawing ominous parallels to the period leading up
to the Asian financial crisis of 1997-98, William R. Rhodes, a senior vice
chairman of Citigroup, pointed out at the institute's news conference that
the previous record of $323 billion was set in 1996.

"You remember what happened after 1996," Rhodes said. "We had 1997. We had
1998. We had the default by Russia, and we had Long-Term Capital Management"
-- a Connecticut hedge fund whose collapse in 1998 triggered a nosedive in
U.S. stock and bond markets.

Another key barometer of market sentiment underscores the optimism that has
taken hold -- the difference between the yield on U.S. Treasuries, the
benchmark for investment safety, and the average yield on emerging-market
bonds. For most of the past decade, this indicator has ranged from 4 to 10
percentage points, but it shrank late last month to a record low of 2.3
percentage points. That means investors are accepting lower interest rates
than ever to compensate for the risks of buying emerging market bonds. In
recent weeks, buyers of Polish, South African, Malaysian and Bulgarian bonds
accepted yields only a fraction of a percentage point higher than they can
get on U.S. Treasuries.

On the bright side, developing nations can borrow cash they need relatively
cheaply on international markets. However, the same applies to countries
with checkered financial pasts, reputations for corrupt government and
worries about political instability. In early October, for example,
Indonesia sold $900 million in 10-year bonds yielding 7.625 percent, and
$600 million in 30-year bonds yielding 8.625 percent.

The money is coming partly from large institutions, such as pension funds
that are devoting greater portions of their investments to emerging markets,
but also from individuals seeking to cash in on the trend. Mutual funds
specializing in emerging-market bonds have had "by far their strongest year
of inflows," according to Brad Durham, managing director of Emerging
Portfolio Fund Research. Emerging market stock and bond funds tracked by his
firm have drawn an estimated $23.2 billion in new funds so far in 2005 --
nearly five times as much as in 2004.

Among the magnets for new cash are the emerging market funds controlled by
Pacific Investment Management Co., the Newport Beach, Calif.-based mutual
fund giant. About $700 million has flowed into the firm's flagship
emerging-market bond fund this year, bringing its assets to about $2.7
billion.

"More and more investors are comfortable with emerging markets," said
Michael Gomez, Pimco's chief portfolio manager for emerging-market funds --
and with good reason, he argued.

As evidence, he cited Brazil's faithful adherence to tough budgetary
targets. And then there's Russia, which "has done a phenomenal job of
self-insuring" against a crisis, Gomez said. The Russian government has used
its oil revenue to build up a hoard of foreign currency reserves that
recently topped $165 billion, even as the government has retired about $20
billion in debt this year.

Pessimists acknowledge that most emerging-market economies are more
conservatively run than they used to be. But they fear that debt burdens
remain dangerously high, even for countries with fiscally responsible
policies such as Brazil. Moreover, they fret about factors that artificially
increase the foreign money flowing into emerging markets.

For example, certain types of hedge funds, which are investment pools for
wealthy investors, have been putting money into emerging markets because
holding a geographically diverse batch of securities can enhance their
safety ratings -- and thus their appeal to clients.

"So you put a little Jamaica in the fund, a little South Africa, a little
Thailand," said Christian Stracke, an analyst with CreditSights, an
independent research firm. "In a global crisis, all three will be a dog. But
if you're a [hedge fund] manager, you don't care. You just want to offer as
much diversification as possible, with as much yield as possible."

In recent reports to clients, Stracke has warned about the rising
vulnerability of Turkey to a sudden withdrawal by foreign investors. "Turkey
is clearly overly dependent on unreliable external capital flows," Stracke
wrote in a Nov. 10 report, noting that over the past three years, the
country has drawn "a whopping $51.6 billion" in such flows -- short-term
bank deposits, for example, that can flee at a moment's notice. The money
has helped to offset a yawning trade deficit that has widened beyond market
expectations, precisely the sort of circumstances that got other countries
into trouble in the past.

Worries were also raised at a meeting in September of finance ministers and
central bankers from the Group of Seven major industrial nations.

"It's something we watch closely," said Timothy D. Adams, undersecretary of
the treasury for international affairs. "We continue to watch it, because
we're paid to worry, and paid to think that benign conditions may be
transitory."