There’s no question the emerging markets are a far stronger asset class in 2007 compared to the basket-case environment that engulfed the region ten years ago. Booming commodity exports, strong GDP growth, bulging trade surpluses and rising foreign currency reserves all confirm it’s a legitimate bull market. Over the last 36 days, the MSCI Emerging Asia Index, excluding Japan, has gained a formidable 30%.
But investors are overlooking serious risks tied to the infamous carry-trade, mainly substantial foreign currency-denominated loans by many smaller emerging markets in Eastern Europe and Asia. In fact, these countries, including the Baltics, Balkans and some of the Asian Tigers have loaded-up on foreign currency loans in low-yielding Japanese yen and Swiss francs; when the tide turns, and it always does, emerging market investors will once again drown in some serious losses.
Specifically, Latvia and Hungary, among others in the region, are the largest violators of the “borrow low and borrow again” thesis. This means borrowing heavily in Swiss francs, the lowest-yielding European currency over the last decade, and taking those proceeds and then borrowing a second time to finance government-backed projects and economic expansion. It’s a recipe for crises, if and when trends in the Swiss franc vis-à-vis the Latvian lat or the Hungarian forint reverse. Both countries, fast-growing markets, have excessive debt-to-GDP ratios and have already been warned on numerous occasions by the European Commission to reduce their reliance on foreign borrowing.
If you think institutions and individual investors were the only ones playing the dangerous carry-trade game, think again. The real Big Boys at this casino are governments in the former Soviet satellite states that continue to pile on mountains of foreign currency-denominated debt to fuel their economic growth. The Swiss franc is the biggest bet at their tables.
One day, the Swiss franc and the Japanese yen will post powerful bull markets again, derailing these countries and most likely acting as one of the catalysts to draw the curtains down on this amazing emerging markets bull.
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