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Low Volatility Is $1.4 Trillion Emerging-Markets Risk, BIS Says

Sunday, September 14, 2014   (0 Comments)
Posted by: Jennifer Bivona
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Low Volatility Is $1.4 Trillion Emerging-Markets Risk, BIS Says

From Bloomberg
By Anchalee Worrachate  Sep 14, 2014 

Some of the very factors that have becalmed developed nations are increasing risks for emerging markets, affecting $1.4 trillion in funds focused on those assets, the Bank for International Settlements said.

Unprecedented stimulus by central banks and historically low volatility (VIX) levels across asset classes have made it more likely that emerging markets destabilize, the Basel, Switzerland-based institution said today it its quarterly report. Governments and companies from Latin America to Asia have boosted borrowing in local and foreign currencies, leaving them more vulnerable when interest rates climb or their exchange rate falls.

The stability that has developed since the worst days of the global financial crisis has encouraged investors to funnel money into higher-yielding assets in emerging markets, swelling them by about 55 percent to $1.4 trillion in May compared with October 2007, the BIS said, citing data from Emerging Portfolio Fund Research Global. That means decisions by money managers to buy or sell have increased impact on these economies, where assets are smaller and less liquid.

The trend is “a potentially important source of concern,” researchers including Ken Miyajima and Ilhyock Shim wrote in the report. “Any decision by asset managers with large assets under management to change portfolio allocation can have a major impact on emerging-market assets that are relatively small.”

Gauges of price swings have fallen toward, or set, record lows this year amid the protracted sluggishness of the global economy. The “exceptionally accommodative policy” of central banks and more transparent communication, including so-called forward guidance on interest rates, played a key role in driving volatility down to these levels, the report’s authors wrote.

Risky Behavior

“An environment of low yields on high-quality benchmark bonds -- coupled with investor confidence in the continuation of favorable market conditions -- is set to foster risk-taking behavior,” the researchers wrote. “As market participants further revise down their perceptions of market risk, they may be inclined to take larger positions in risky assets, boosting prices and pushing volatility even lower.”

There are signs that may be starting to turn around.

Volatility among global currencies rose the most since May 2012 last week, JPMorgan Chase & Co. indexes show. Bank of America Merrill Lynch’s MOVE Index, which measures price swings in Treasuries based on options, was at 66 basis points on Sept. 12. That’s up from this year’s low of 52 basis points though short of its 10-year average of 91 basis points and

The Chicago Board Options Exchange Volatility Index, or VIX, also climbed since touching the lowest level since 2007 in July.

Common Benchmarks

Another challenge facing emerging-market nations is the asset-management industry’s use of common benchmarks and relative-performance measurement, which may lead to herd behavior, according to the BIS, the organization that acts as a central bank for the world’s monetary authorities.

“In particular, there is a higher degree of concentration in the use of benchmarks by asset managers investing in emerging-market assets” than those investing in developed markets, the analysts wrote. That is a factor that raises the potential for “one-sided markets.” In the past two years, “investor flows to asset managers and emerging-market asset prices reinforced each other’s movements.”

In the foreign-exchange market, suppressed price swings increased the attractiveness of carry trades that target emerging-market currencies, the report said.

Carry Trades

Carry trades exploit differences in global interest rates and reduced volatility makes profits more reliable. Investors using the euro to fund purchases of the Brazilian real, for example, would have made a 15.3 percent return this year through 6:30 p.m. London time Sept. 12, data compiled by Bloomberg show. The Standard & Poor’s 500 Index (SPX) gained about 9 percent during the same period.

The low volatility and interest rates also raised risks among corporate borrowers, the bank said.

Companies in major emerging-market countries have increased their borrowing in foreign currencies as they took advantage of low financing costs. Private-sector borrowers excluding banks in major developing economies sold almost $375 billion worth of international debt in 2009 to 2012, according to the BIS. That’s more than double the amount in the four years before the crisis, it said.

“The share of debt denominated in foreign currency is very high, and there is reason to believe that many emerging-market corporates are unhedged against this exposure,” the report said. “Together, with their increase in leverage, this raised the vulnerability of emerging-market corporates to the combined effects of a domestic slowdown, currency depreciation and a global rise in interest rates.”

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