Capital Flight or Foreign Investment -- or History?

There are mixed signals for the global economy.

As recently as ten years ago, emerging markets still held their hands out for development loans and foreign aid. Today, their fiscal prudence and wealth has put them in the position of bailing out the western banking system.

Why are investors taking so long to realize this critical distinction and its meaning?

Inflation is rising at a time of global slowdown. The US economy is weakening while commodities soar. There may be both inflation and slow growth in the US, and maybe also in Europe, but both the growth and inflation pictures may look very different in emerging markets. From low levels, inflation has risen with strong upsurges in domestic demand in emerging markets. However, growth will continue to be robust, if slightly down.

Resurgent inflation is a more global problem in my view than slowdown, which appears to be largely limited to the US, albeit with possible spillovers to Europe coming.

Gross national savings are over 30 per cent of GDP on average in emerging countries, and for a decade private and official savers in these countries have been investing overseas – in the US and Europe – under the impression that these were safer markets than at home.

Yet the dollar is far from the safest currency and not the store of value it was. US Treasuries are not zero risk – the implicit myth in the term “the risk-free rate”. Treasuries have currency, curve and volatility risks. Investors in triple A structured credit got a shock when they realised their investment was risky. Likewise emerging market savers are getting a shock about Treasuries and other US and European assets.

The money is returning home, and the move is structural, not cyclical.

The global imbalance of a negative US personal savings rate on the one hand being financed by high emerging savings on the other is starting to reverse. With this reversal, or rebalancing, is coming, I believe, a currency realignment and a series of investment booms across emerging economies as investment focus shifts. Rather than using “decoupling” in describing the impact of the credit crunch on emerging markets, we should use “negative correlation”.

Many central banks in emerging markets know the costs of inflation and the need to move fast in preventing it. The widespread implicit assumption that emerging market central banks will simply allow inflation to rise without taking action is broadly incorrect in my view. In some countries interest rates have started to rise and exchange rates also, though both these dynamics have further to go.

Whatever the choices of individual countries, the logic of global rebalancing remains: if the rest of the world is tiring of financing the US, then the US current account deficit has to shrink and US goods and services need to become cheaper in real terms vis-à-vis emerging goods and services. It is not credible that the world will revert to the same level of capital flows to the US after the credit crunch is over. The least painful way to do this is through gradual exchange rate appreciation of emerging currencies.

The policy asymmetry between the US and emerging markets is that the emerging markets, with undervalued currencies, have an additional degree of freedom. They have the choice to mess up (do nothing) or control inflation (let the currency rise, raise interest rates). I believe that emerging market central banks will largely pass this test and do the sensible thing, though this is not what the market appears to have priced in yet.

The US must hope for the best. Ben Bernanke, chairman of the Federal Reserve, has focused on lower rates to cope with a slowdown. If currency weakness is gradual over the next couple of years, this will cause gradual importation of inflation, balanced by the US domestic slowdown’s deflationary impact. If, however, currency adjustment is quick, the US has little policy scope to avoid stagflation.

The most important impact of the credit crunch on emerging markets may be through asset allocation, starting with an inflow into emerging local currency debt, and then real investments. The emerging market private and public sector investor has for years been investing overseas: into the US and Europe. This has been to reduce risk, to get out of the home market.

This used to be called capital flight, is now called foreign investment, and may shortly be history.