Brazil's decision to float its currency raises the question of whether global emerging market investors will start switching out of Asia back into Latin America, a reversal of the asset allocation move that has been under way since the beginning of the final quarter last year. The argument is that interest rates in Brazil will fall now that the country has gone into a free float and backed that policy with high real rates.
This argument rests on three assumptions. First, that shares are cheap in Brazil, which they currently are. Second, that Latin America will avoid the regional currency contagion seen after the Thai baht was devalued. The fault line in this assumption clearly lies in Argentina, and, in Greed & Fear's view, Argentina will stick to convertibility as it did after the Mexican peso devaluation in 1985. Third, investors assume that Brazil's Congress will finally approve the necessary actions to address the country's chronic fiscal problems. This last assumption is the most problematic. Still, the widespread trend of moving money out of Latin America into Asia must now be called into question.
In the wake of the Brazilian currency collapse, the last major edifice left to topple in the global emerging markets universe is clearly Hong Kong/China. Greed & Fear continues to hold the view that both the Hong Kong dollar and the renminbi will ultimately fall victim to the deflationary wave hitting greater China.
The Hong Kong dollar peg has more credibility than the real because it is a currency board system like Argentine convertibility. In this respect, the fate of the real plan offers further proof that crawling pegs are destined to self-destruct, since it is not possible to control both the money supply and the exchange rate simultaneously. Witness what happened to both the ruble and the rupiah.
The contrasting options of a floating exchange rate or a currency board recognize this reality. The question (previously discussed here), is whether Chinese political will can sustain the Hong Kong dollar peg through a deflationary adjustment. The Hong Kong authorities' various interventions over the past year suggest otherwise, in contrast to the situation in Argentina. For the moment, however, the markets are not really putting Chinese resolve to the test.
It's surprising that increasingly troubling news from China regarding international trust and investment companies, or ITICs, and other financial frailties of China-related companies has not caused a bigger jump in the Hong Kong risk premium as measured by Hibor. Still, any rise in the risk premium is bearish in the present environment of high real interest rates, since it delays the process of lowering nominal interest rates.
Hong Kong's umbilical-like attachment to China prompts renewed concerns about the renminbi. Hong Kong remains the fault line to transmit market concerns about China, protected as it is behind a closed capital account.
Greed & Fear continues to favor Korea and Singapore as the two major liquid markets in the Asia-ex-Japan universe. The best argument for Hong Kong is investors' current willingness to put some money to work in Asia-ex-Japan.
Greed & Fear has been visiting American investors over the past few weeks. Two observations stand out. First, most global investors missed the rally of the last quarter of 1998. Second, there is a desire to invest in Asia but no great inclination to chase prices, especially as global funds continue to play the restructuring M&A game in Europe despite surging multiples and growing evidence of a deflationary slowdown there.
Another virtue of Hong Kong is simply that it is the most liquid market, with a dominant 40% weighting in the relevant index. It is therefore somewhat dangerous to be underweight Hong Kong. Still, Greed & Fear will retain this view since greater China is the one part of Asia where economic crisis has yet to come to a head. Korea and Singapore, by contrast, now have restructuring stories going for them. These stories are believable precisely because they are being driven, top down, by the governments themselves. By contrast, there is as yet no clear policy in Hong Kong.
Christopher Wood, the author of Greed & Fear, is the global emerging market strategist for Santander Investment. He is the author of The End of Japan Inc. (Simon & Schuster, 1994). Under no circumstances is this to be used or considered as an offer to sell, or a solicitation or recommendation of any offer to buy.