SIZZLING EMERGING MARKETS RISK OVERHEATING / THE WALL STREET JOURNAL ( HIGHLY RECOMMENDED READING )

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OCTOBER 14, 2010, 11:09 A.M. ET.

Sizzling Emerging Markets Risk Overheating

By RICHARD BARLEY

Emerging markets are red hot, but will they become too hot to handle?

A combination of strong domestic growth and exceptionally loose monetary policy in the West is fueling huge flows into emerging markets.


Emerging-market equity-fund inflows hit a 33-month high last week of more than $6 billion, according to data group EPFR Global. Emerging-market debt specialist Ashmore said Wednesday that inflows helped lift assets under management by 18% in the third quarter. Investors should remember the risks.


There are already some signs of overexuberance. Mexico recently issued 100-year bonds. The cost of insuring junk-rated Indonesia's sovereign debt is only marginally above that of double-A-rated Belgium. Emerging-market corporate debt issuance is booming, although so far yields remain high. Equity valuations, at least, still look reasonable, with the MSCI emerging-market index on a forward price/earnings multiple of 11, below the 20-year average of 13.7, according to HSBC. The Standard & Poor's 500-stock index, by contrast, is on 14 times.


Markets may yet go much higher. Emerging-market fundamentals are strong. The International Monetary Fund says advanced economies will grow 2.7% in 2010 but emerging economies will streak ahead 7.1%.


Emerging market debt-to-GDP ratios and budget deficits are generally more comfortable than in the West. And with a combined $5 trillion in foreign-exchange reserves, emerging markets have a big cushion against future financial crises.


More importantly, emerging markets are grossly under-represented in many investors' holdings. Emerging-market countries will account for 47% of world GDP this year, yet almost none of the $16 trillion of Organization for Economic Cooperation and Development pension-fund cash is in emerging-market debt, an $8 trillion asset class, according to J.P. Morgan. Similarly, emerging markets account for 31% of global stock-market capitalization but only 6% of developed-market institutional investor equity portfolios, Goldman Sachs estimates.


But investors dazzled by growth may be underestimating the political, legal and institutional risks. South Korea, Thailand and Brazil have already introduced controls to fend off sharp currency appreciation fueled by US. monetary policy; others may follow. Alternatively, central banks may hold off rate hikes to avoid further "hot money" flows but thereby risk new asset bubbles and inflation. Liquidity remains a concern: if risk aversion in emerging markets builds, the rush of cash for the exit could be huge and destabilizing.


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