9 August 2015
The August Newsletter offers three vacation-light notes on commonly used but as shall be argued here inadequate investment terms and concepts
The meaning of the label emerging markets has become increasingly controversial. Some argue it has become obsolete (see e.g. Financial Times, 3 August 2015, Emerging Markets: Redrawing the world map). It seems fair to argue that it has. But replacing it with something better is not obvious (see also Financial Times 16 March 2015, Why Wimp label sticks to emerging markets).
The origins of the term emerging markets are well known. Its use in portfolio investments as an aspirational term to denote investment innovation is broadly understood. The term served well to draw portfolio investor interest into a then new asset class. At the same time, it has established certain barriers of entry and discontinuities in terms of countries’ investment attributes. This could indeed be problematic to remain attractive.
The main concern about the term emerging markets seems twofold: It conveys the notion that emerging markets as a group are riskier than advanced economies as a group that is no longer appropriate; emerging markets have become too dissimilar to be combined under a single header. The first can be measured by inter-country group riskiness and the second by deviations from intra-country group riskiness.
Countries’ riskiness can be approximated broadly by economic indicators. The vulnerability index (see Countries' economic vulnerabilities (update) for details) serves as a summary indicator including GDP growth, inflation, general government net lending, general government gross debt, current account balance and total investment. The index scores the 6 indicators from 0 to 7, where a higher number is given for a weak economic indicator, e.g. high debt, and can range from 0, no vulnerability, to 35, high vulnerability. The indicator is calculated for the 50 largest economies (2013) of which 30 are emerging markets. The level of the vulnerability indicator of emerging markets relative to advanced economies indicates relative riskiness, where an index above 1 shows an average vulnerability index higher for emerging markets than for advanced economies. The deviations of the vulnerability index of the individual emerging markets relative to the emerging markets average vulnerability index over time indicates whether emerging markets become more or less different. The vulnerability indicator has its obvious limitations by excluding non-economic factors, history of impairment and private sector indicators.
The vulnerability indicator shows that emerging markets have been on average between 2001 and 2013 less vulnerable than advanced economies and that emerging markets have become increasingly heterogeneous (Chart).
The vulnerability index suggests that perception of emerging markets riskiness is not principally driven by economic factors. The increasing heterogeneity of emerging markets may point out that indeed the emerging markets label is no longer fitting.
The emerging markets term naturally represents an average perception. Most investors, it shall be assumed here, would typically not aspire to averages in other aspects of life. Few may have but would in principle not just want an average house, average children or an average wife or husband, spend an average holiday and eat average in a restaurant. Most would want to be selective. Search costs seem to prevent investors from being more selective. Hence, emerging markets need to do more to reduce search costs and differentiate themselves from emerging markets to remain attractive.
The debate about international currency diversification has focused predominantly on the renminbi. Speculations seem rife as to when the renminbi will replace the dollar as the dominant reserve currency. The fact that such speculation is taking place is itself indicative how much the international economy has changed (see e.g. The Economist, 1 August 2015, If the yuan competes with the dollar ). At the same time it serves as a reminder how little has changed.
The debate seems to be guided by the assumption that the international economy has a preference to cluster around a dominant currency. The dominant role of the dollar suggests this is the case. The so-called network externalities of using a single currency, similar to the advantages of using a single language, seems to support the case for currency dominance. The case against a dominant currency seems to rest largely in the advantages of diversification, that is, it is too risky for the international economy to be dependent on a dominant currency if domestic interests of the issuer deviate strongly from the interests of the rest of the world. This is in essence the implication of the Triffin Dilemma. The now expected increase of the U.S. monetary policy rate is a case in point.
The circumstances that have led to dollar dominance have been unique and rest in the circumstances after World War II. The dollar at the time was the only convertible currency readily usable for international transactions. Britain’s policy objective to reduce the international role of sterling during the 1960s and 1970s has given further room towards dollar dominance. The earlier adoption of convertibility and development of European currency markets brought eventually about a significant decline in the dollar dominance during the 1980. It was the emerging markets starting during the 1990s and then in particular during the 2000s that revived dollar dominance (Chart).
China and the emerging markets may now be where Europe was during the 1960-70s. China has, similar to Europe at the time, signalled strongly its desire to have its currency play a more prominent role in international transactions. At the same time, the proliferation of European currencies with the post-war recovery of Europe reduced dollar dependence but was not geared towards supplanting the dollar (the euro may have made some attempt in that direction). The increasing diversification of the international economy seems more consistent with the notion of increasing international currency diversification.
The renminbi will improbably remain the only serious international newcomer. While the dollar is likely to continue as the most important currency for some time, more international currencies are set to assume smaller international roles. Technology allows to reduce transaction costs of smaller currencies. Diversification rather than dominance should be the mantra for the international economy.
The economic and financial crisis has highlighted the advantages of having a lender of last resort. Commentators would frequently cite the fact that some central banks can conduct large asset purchases representing a key advantage to preserve supportive financial conditions. The significant purchases of government securities by the Bank of England, Bank of Japan and Federal Reserve have financed directly government debt and indirectly lowered interest rates on government debt. This seems to defy conventional wisdom that central banks should not finance their governments and/or not offer emergency liquidity unconditionally. New central banking rules seem to be required.
The notion of lender of last resort has predominantly been used to denote a central bank offering emergency liquidity assistance to its domestic banks. The concept was meant to apply to supporting illiquid but solvent institutions (the line between illiquidity and insolvency is naturally a very thin one). The IMF can also be considered a lender of last resort to governments. Both central bank assistance to banks and IMF assistance to governments have normally be tied to strict conditionality for obtaining financial support. Nowadays, central banks lend unconditionally to governments. While quantitative easing has been presented as a means to provide extraordinary liquidity, it has been an extraordinary means to fund governments blurring beyond recognition the lines between monetary and fiscal operations.
Restricting central bank monetary financing to governments has not too long ago been adopted as a generalised concept. The Bank of International Settlements (BIS) summarises current practice (BIS, Issues in the Governance of Central Banks, May 2009): “Restrictions on inflationary financing of the government are a means of deterring fiscal dominance. Legislation in a number of countries either forbids direct central bank lending to the government, restricts it to highly exceptional circumstances or sets clear quantitative limits. Often, restrictions are implied by the central bank having policy independence and no obligation to lend to the government.”
The restrictions on central bank government financing has prominently been adopted by the EU with the Maastricht Treaty (Treaty of the Functioning of the European Union, Article 123): “Overdraft facilities or any other type of credit facility with the European Central Bank or with the central banks of the Member States (hereinafter referred to as ‘national central banks’) in favour of Union institutions, bodies, offices or agencies, central governments, regional, local or other public authorities, other bodies governed by public law, or public undertakings of Member States shall be prohibited, as shall the purchase directly from them by the European Central Bank or national central banks of debt instruments.” While the Maastricht Treaty prohibits only primary market purchases, the economic and financial effects of secondary market purchases seem obvious.
The restrictions on central bank government financing was seen as essential to ensure central bank independence and as necessary for monetary policy effectiveness. The crisis has required extraordinary measures. In principle one needs to be pragmatic. However, the risk is now that what have been extraordinary measures will become routine. While central banks have frequently held including large amounts of government debt mostly within the conduct of open markets operations to affect domestic liquidity conditions, the scale and timeframe within which such government debt purchases took place matter. The Bank of Japan and Bank of England seem by far the biggest government lenders.
The notion of central banks being lenders of last resort for national governments is a novel concept. Its meaning should not be taken as given. It may change prevailing best practices about central bank policy conduct, central bank independence and central bank governance. Central bank policy conduct is at risk as policy objectives and policy instruments become increasingly ill defined. To promote central banks’ as lenders of last resort to governments as best practice would require redefining central banking and reordering central bank objectives. Unfortunately so far, rules have just been broken. They need to be rewritten.