Tags: Japan | Shock | Emerging | Markets

Japan's Shock Therapy Risks Disturbing Emerging Markets

Sunday, 21 Apr 2013 11:43 AM

 

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A steady flow of cash into emerging markets could become a flood as the Bank of Japan's huge stimulus program may prompt the nation's investors to chase higher returns - but for some developing countries that could be too much of a good thing.

The fear is that a big fresh influx of foreign money could overheat those markets, triggering higher prices and pushing currencies higher, which would make a country's exports more expensive while pulling in cheaper imports that could hit domestic producers. The money may also disappear as fast as it arrived if returns became better elsewhere.

Global investors were loading up on Mexican, Russian and other bonds even before the Bank of Japan (BOJ) announced on April 4 its attempt to end decades of stagnation by pumping $1.4 trillion into the economy. Global inflows into local currency emerging market debt funds in the first quarter were the biggest in two years, Thomson Reuters' Lipper service data shows.

A 15 percent drop in the yen so far in 2013, and a 28 percent gain in Japanese stocks, has prompted Japanese investors to bring some cash back home in recent months. But analysts expect Japan's appetite for foreign assets to increase again given low yields on Japanese deposits and bonds.

"A lot of money is still likely to leave Japan," said Citigroup currency strategist Steven Englander. "Some of it has to go into emerging markets."

Bank of America Merrill Lynch estimates that Japanese retail investors, collectively referred to as "Mrs. Watanabe," the mythical manager of household savings, hold some $16.8 trillion in assets, with a bit more than half in deposits and cash.

Emerging markets, with their strong growth rates and high interest rates, "may attract a significant portion of these savings," strategists at Bank of America told clients in a recent note.

Concerns that money created by central banks, such as the U.S. Federal Reserve and the BOJ, will pour into developing markets was high on the agenda of the finance leaders of the G-20 group of advanced and emerging economies this week in Washington.

In a communique after the meeting, G-20 leaders said they would be "mindful" of side effects of extended monetary stimulus.

"Monetary policy should be directed toward domestic price stability and continuing to support economic recovery, according to the respective mandates of central banks," the statement said.

HUNTING FOR YIELD

In the past five years, emerging economies have accounted for almost three-quarters of global growth, the IMF says.

That's fueled a big move into local currency funds, which pulled in more than $16.7 billion in the first quarter of 2013, the best this relatively young sector has seen in more than two years, according to Lipper. Hard currency funds attracted cash in the first three months of the year, albeit at half the pace seen in the fourth quarter.

The inflows come despite disappointing returns so far in 2013. Local currency debt funds lost 1.05 percent while hard currency debt funds dropped 2.2 percent in the first quarter.

 

There was a surge of inflows into Japanese "toshin" investment trusts - funds with exposure to foreign assets - late in 2012, but Japanese investors repatriated funds heavily in February and March. The Nikkei 225's rally was partly due to expectations a weaker yen would boost export revenue for Japan's top companies.

Still, analysts at Nomura expect "toshin momentum to recover gradually, as retail investors have clearly become more risk-tolerant." Recent Ministry of Finance data showed flows into these investment trusts hit a seven-month high in March.

Emerging market assets remain attractive thanks to higher yields vs record low rates in Japan. In Mexico, Brazil, Russia and South Africa, sovereign bonds offer 300 to 900 basis points more in yield than Japanese government bonds. Many expect the BOJ's stimulus to push yields on 10-year Japanese bonds, currently at 0.6 percent, even lower.

"If you think U.S. investors are yield-starved, remember, we're only five years into this period of low rates. The Japanese are 20 years in," said Brendan Clark, president of Clark Capital Management Group in Philadelphia. "They are absolutely going to be looking for yield."

To be sure, a healthy share of assets will almost certainly flow into U.S. Treasuries. Even with Treasury yields near record lows, the 1.70 percent earned on a 10-year U.S. note is more than a percentage point better than comparable Japanese bonds.

And some investors say the impact on some emerging markets will be modest.

"On the margin it will benefit emerging debt, but you shouldn't go head over heels thinking this is a big bazooka that will bring floods of liquidity into every market," said Steve Ellis, who runs an emerging market debt fund at Fidelity Worldwide Investments in London.

According to Lipper, the highest percentage of Japanese inflows into emerging-market debt have been into Turkey, Indonesia and Mexico. Flows into Japanese-domiciled funds that invest in Brazilian debt were strong through the end of 2012, but since then they have seen three months of outflows.

Japanese interest in funds that focus on currencies, so called double-decker funds, has begun to recover after slumping from a high reached in 2010. Lipper Japan data shows inflows rose to nearly 776 billion yen ($7.91 billion) in the first quarter, the highest inflow since the third quarter of 2011. Funds that tap the performance of Brazil's real and Turkey's lira drew the most interest.

POTENTIAL BACKLASH

Global investors eager to ramp up exposure to emerging markets will have to tread carefully, though. Too much money could provoke inflation and instability in some emerging markets and push their governments to retaliate with capital controls and currency intervention, beyond what's in place already.

Latin America has absorbed $400 billion in foreign investment into financial markets in the last five years, and excessive currency gains could hurt their exporters.

BOJ Governor Haruhiko Kuroda said on Thursday he did not see signs of asset price bubbles "brewing in emerging nations", but said stimulus "may affect emerging economies including through capital inflow."

In 2010, when a wall of money washed onto Brazilian shores and pushed its currency, the real, to successive highs, about $26 billion came from Japanese currency-focused toshins, Lipper data showed. They were lured by a 12.5 percent benchmark interest rate in Brazil at that time.

That rate has fallen since but it was lifted to 7.50 percent from 7.25 percent on Wednesday as Brasilia tries to curb inflation. Flows into Japanese funds focused on the real rose to $2.93 billion in the first quarter, the largest quarterly inflow since the third quarter of 2011, Lipper data shows.

A tide of new money could also test the reform-minded Mexican government's commitment to free-floating exchange rates, though some say lower yields in Mexico should keep incoming flows from matching those that swamped Brazil.

"Compared with the nightmare Brazilian authorities experienced, Mexican authorities will sleep well," said Yujiro Goto, an analyst at Nomura Securities in New York.

© 2014 Thomson/Reuters. All rights reserved.

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