- The Washington Times - Friday, October 9, 2009

Stock markets in major emerging countries such as China and Brazil have been on fire this year, attracting a wave of investment from the United States and rest of the world as well as driving down the value of the U.S. dollar.

The dollar’s decline — it hit a 14-month low against major currencies Thursday — is adding to sizzling returns for investors in emerging markets and has helped spur American exports. But it also has raised worries among international finance officials and American consumers who have seen their currency rapidly lose purchasing power and prestige in recent months.

Stock indexes in many of the emerging economies from South Africa and Russia to South Korea and Taiwan are on track to gain from 50 percent to 100 percent or more this year, compared with the 10 percent to 20 percent returns expected in U.S. markets.

Investors in foreign markets are benefiting from the rise of foreign currencies against the dollar, which can double their returns. That makes it an irresistible trade even for American investors, who have been pouring $30 billion a month into foreign markets.

The worldwide investment binge in emerging markets — and some developed countries such as Australia and Canada that benefit greatly from trading with them — has emerged as a key reason behind the rapid decline of the dollar this year. The dollar’s decline, in turn, has been feeding inflation fears and talk about finding a way to end the dollar’s status as the world’s principle reserve currency.

Laza Kekic, analyst at the Economist Intelligence Unit, a London-based research and advisory firm, said big emerging countries such as Brazil and China are being rewarded for their good economic management in recent years that included using some of the burgeoning revenues from their exports to the developed world to pile up huge reserve funds that helped them to weather the global economic crisis in the past year.

That contrasts with the big debts and paltry savings and reserves in the United States and some other developed countries — a trend that not only fueled the debt crisis but continues to hold growth back in those countries as consumers, banks and businesses struggle to cope with a legacy of debt and default.

“The emerging markets have held up better because their overall economic performance has been much better than that of the developed world, which has experienced its worst recession since the Second World War,” Mr. Kekic said.

While much media attention has focused on India and China, which never stopped growing even while the developed world was in deep recession, other emerging markets such as South Korea and South Africa also weathered the global recession very well, showing for the first time they could “decouple” from the developed world, he said.

As a result of their superior economic performance, emerging markets for the first time in years are expected to attract more direct investment from the outside world in businesses and properties than the United States and other developed countries in 2009, he said. The United States in past years attracted the most foreign investment.

While the rise of developing countries need not be a detriment to the United States, it is hurting the U.S. currency in a way not seen before. Investors worldwide are dumping their dollars to buy into foreign markets, driving down the value of the currency.

Worsening the trend, big investors including New York hedge funds are employing a technique that enhances their returns by first borrowing money in the United States, where short-term interest rates are close to zero, and then investing that money in emerging markets.

The tactic, called the “dollar carry trade,” enables traders to leverage their investments several times over and take advantage of the diverging currencies, further multiplying their returns. To complement this leveraging strategy, some hedge funds are profiting by “shorting” the dollar, or betting that it will decline. All of this leads to even more intensive dollar selling.

The emerging market countries have become a powerful force propelling the dollar’s decline as they have been dumping large shares of the dollars they receive from investors and exporters and exchanging them for euros and other currencies in a drive to diversify their reserve holdings.

While these investment strategies have yielded triple-digit returns for many investors, they are widely acknowledged to be risky, as emerging markets remain highly volatile and the global economic recovery remains far from certain.

“The spectacular rally in emerging markets looks like another bubble in the making,” said Robert P. Smith, a former emerging market trader and author of a book on global investment.

As with past bubbles in housing and credit, many analysts suspect a bubble in world stock markets — including U.S. markets — is being fueled by a revival of leveraging strategies on Wall Street, easy money and extremely low interest rates engineered by the Federal Reserve and other central banks.

Hedge funds and other leveraged investors are counting on the Fed maintaining short-term rates near zero for at least another year — a safe bet as Fed Chairman Ben S. Bernanke on Thursday repeated the central bank’s intent of keeping rates low for “an extended period” until it becomes clear the economy is in a self-sustaining recovery.

“Excess liquidity is buoying risky assets indiscriminately, while punishing the dollar,” said David Woo, currency analyst at Barclays Capital. He expects the boon for stock markets and the downturn for the dollar to continue until the Fed signals that it is ready to start withdrawing liquidity from financial markets, probably early next year.

Mr. Smith said he is skeptical of the “decoupling” theory feeding the emerging market frenzy. He questions how countries such as China and South Korea, whose economies in the past have relied heavily on exports to the U.S. and other developed countries, can keep growing robustly while Western consumers remain in the doldrums.

While China had a powerful stimulus program that independently propelled world growth for a time this year, “much of the stimulus may be going to politically connected loss-making enterprises and thus will result in no lasting growth,” he said.

“We may discover in a few months that the rich valuations at which we now buy emerging market shares are unsupported by the risk adjusted prospects for earnings, and experience sharp losses,” Mr. Smith said.

“China and other emerging economies have demonstrated over the last year that they can continue to grow while the West is in recession, but a stronger and more sustainable recovery still requires a revival of Western economies,” said Jan Randolph, analyst at IHS Global Insight.

• Patrice Hill can be reached at phill@washingtontimes.com.

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