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Winter Forum - February 22, 2011

Speakers Debate Effectiveness of Capital Controls, and Discuss Eurozone Issues at London Winter Forum

EMTA’s Eighth Annual Winter Forum was held in London on Tuesday, February 22, 2011. JPMorgan hosted the event at the historic Great Hall, with 150 EM professionals in attendance.

JPMorgan’s Joyce Chang began the event’s first panel session by reviewing forecasts on key economic variables provided by her co-panelists. Chang noted that all participants expected further commodity price rallying and forecast a slight tightening of the EMBI in 2011, but differed on their SELIC rate opinions.

Chang then noted that EM policymakers have become increasingly reliant on “macroprudential” measures such as credit targeting and capital controls, rather than traditional monetary tightening, to manage their economies. She asked panelists to assess the effectiveness and sustainability of such measures, particularly in the face of rising inflation, and an obvious consensus soon emerged. David Lubin (Citi) noted that the approaches taken by Brazil and Turkey represented the two opposite ends of the spectrum in the use of macro-prudential measures: Brazil has combined them with rate hikes and controls on capital inflows, while Turkey has combined them with rate cuts. Lubin cautioned that Turkey’s choices were “unwise” and were “likely to prove less effective.” In addition, the market was clearly pleased with the Brazil’s conventional measures, he stated, a further incentive for their adoption.

Credit Suisse’s Kasper Bartholdy concurred in criticizing Turkish policy; “they will discover that they will have to reverse course and raise rates.” Guilherme da Nobrega of Itaú BBA contributed to the praise of Brazilian Central Bank actions. It has proven effective, he stressed, and he expected additional SELIC hikes in coming months.

Turning to inflation, speakers discussed the causes of EM inflation. Lubin described it as a result of three main forces -- disappearing output gaps, loose monetary conditions and rising food prices (part of a vicious cycle of food and energy prices feeding on each other). Inflation-targeting as a strategy for Central Banks was “dying a slow death,” as in the post-Lehman crisis officials had moved away from an exclusive focus on inflation rates. Now that this Rubicon has been crossed, even with inflation pressures rising, the genie will not be put back in the bottle, Lubin surmised.

Chang observed that there appeared to be greater market complacency regarding the Eurozone crisis in recent weeks and asked if decreased concerns were justified. Arnab Das (Roubini Global Economics) stated that Eurozone officials had talked up expectations while ultimately disappointing the market after their most recent meeting. “They are doing the absolute minimum politically…they need to wake up,” he argued. While the problem could remain limited to Portugal, Ireland and Greece, Das cautioned that investors should remain on their toes in their assessment of Spain.

Although capital inflows to EM have been modest in comparison to 2010 (and could even turn negative in 1H 2011), Bartholdy viewed this as a temporary, rather than long-term, phenomenon, based largely on fears of EM inflation and increased valuations. Chang noted that JPMorgan still has optimistic views on capital inflows, although their composition would change as strategic investors possibly replaced retail accounts.

As for Brazil, da Nobrega believed that the market has not given the new administration sufficient credit for its actions. He expressed optimism and saw increased determination by officials in slowing the economy down. At the same time, with inflation possibly 200 bps above target, the Central Bank faces a struggle to regain credibility and “we will have to expect higher inflation in Brazil than in the recent past.” Economic policy in Brazil evolves on a daily basis rather than being set in stone, and Da Nobrega expected budget cuts to exceed the BRL50 billion initially announced. On the other hand, he expressed disappointment in the greater lending that has been conducted via the BNDES.

Concluding with trade recommendations, Bartholdy saw value in sovereign CDS, preferred to receive rates in Brazil and Malaysia, and favored currencies such as the renminbi, zloty, shekel, Turkish lira, Mexican peso and Indian rupee. Lubin would buy Israeli CDS as a hedge on Middle East uncertainty. Das would underweight equities and believed there were opportunities in peripheral Europe. Chang forecast a tougher year, but underscored that “returns of five to eight per cent will still outperform alternative asset classes.”

Following the first session, Kevin Daly of Aberdeen Asset Management moderated the event’s panel of investment specialists.

Daly noted that the revolutions in Tunisia and Egypt had served to remind investors that many EM countries remain exposed to political risk. In the aftermath of these dramatic events, what new risks should investors consider? Mohammed Hanif, whose fund (Insparo Asset Management) specializes in the MENA region, pointed out that the different demands by protestors and the varied types of regimes make it hard to find common threads and explain contagion effects. However, investors should focus on increased political risks in the region, with an upheaval in Saudi Arabia as the greatest potential issue. “Protests in Saudi Arabia could only be resolved by regime change or liberalization…what would Saudi do?” he pondered. Moore Capital’s Gene Frieda largely concurred, while adding that upheaval in Iran would also be a major concern.

John Carlson (Fidelity Investment Management) expressed surprise that spreads have not widened more dramatically on MENA debt. “I don’t think we have stepped back enough to analyze the situation….the changes in geopolitics could take years to resolve,” he stated. Helene Williamson (F&C Investment Management) added that the fiscal consequences of the political unrest in Egypt (e.g. higher food subsidies) are clearly not priced in either. Other fat-tail risks mentioned were Pakistan and potential social unrest in the Euro-periphery given that real wages need to adjust downwards substantially.

Discussing inflation concerns and fears that Central Banks might be acting too slowly to counteract it, Carlson believed officials could gain the upper hand in battling price increases. “It is clear that monetary policy is still loose in EMs whereas it should be tightened,” stated Frieda, who underscored that “a major structural change is China’s moving from an exporter of deflation to an exporter of inflation.” Moves to address inflation via reserve requirement hikes don’t work, Frieda argued, creating “an accident waiting to happen.”

Several speakers addressed flows into the asset class. Williamson noted that the market had priced in a lot of good news in 2010, and was probably undergoing a “health correction.” Carlson noted that there have been outflows from the asset class in recent weeks, but believed that these were by accounts that did not have a thorough understanding of the asset class. Daly expected institutional investors to eventually increase their allocations to EM debt despite the current outflows from retail investors.

The panel also discussed their macro calls on China, and FX rates. Carlson spoke positively on the US$ on a long-term basis, citing the US government being able to eventually “put the fiscal house in order, which it will.”

Were speakers tempted by Eurozone peripherals? Frieda noted that there could be opportunities for investors, although Daly had avoided them thus far. “Greece is a difficult call, but Ireland –with elections coming up - are likely to seek a haircut on senior bank debt, which reduces the risk of a sovereign debt restructuring,” Daly stated.