A bullish view has "held that emerging market (EM) central banks built up robust international reserve positions (including large quantities of Treasuries) that would be available to backstop their systems in the event of global market turbulence.
Well, a surge of outflows (and currency market intervention) coupled with a spike in yields is now in the process of depleting reserves much more quickly than anyone had anticipated. There is a clear possibility that we're early in what could be unprecedented flows seeking to exit the faltering EMs. Recalling the 1997 Southeast Asian experience, it was a case of "those who panicked first panicked best". The more reserve positions were depleted, the faster "hot money" ran to the rapidly closing exits.
As a rough guide, the pain and dislocation associated with a bursting bubble are commensurate with the degree of excess during the preceding boom.
Timing a bubble's burst is always a challenge (at best) - especially in an environment of epic central bank liquidity support.
Importantly, the longer the inevitable day of reckoning is delayed the worse the consequences. Years of aggressive market intervention ensured a most protracted period of unprecedented excess - excesses that encompassed virtually all markets and all risk categories. Perhaps Federal Reserve policymaking ensured that the greatest bubble excess and market distortions materialized in perceived low-risk (fixed income and equities) strategies.
"The danger of mis-pricing risk is that there is no way out without investors taking losses. And the longer the process continues, the bigger those losses could be. That's why the Fed should start tapering this summer before financial market distortions become even more damaging." Martin Feldstein, Wall Street Journal op-ed, July 2, 2013.
Never have inflated bond prices - artificially low borrowing costs - had such a profound impact on securities and asset pricing around the world. Never have risk perceptions and market risk premiums in general been so distorted by aggressive central bank market intervention.
The mis-pricing of risk implies market re-pricing risk. And the greater the scope of mis-pricing - in the volume of securities issuance, price level distortions and risk misperceptions - the greater the scope of latent bubble market risks. Mis-pricing also implies wealth redistribution - and this has traditionally been from the less sophisticated to the more sophisticated. Actually, when enormous quantities of non-productive debt are issued at artificially high prices there is initially a perceived increase in wealth (more debt instruments at higher prices). This debt ("bull market") expansion coupled with perceived wealth creation spurs spending, corporate profits and higher equities and asset prices. But when the bubble begins to falter - with re-pricing, market losses, risk aversion and tightened financial conditions - the downside of the credit cycle commences".
Source: AsiaTimes
