The recent few years are marked by a significant growth in financial transactions, stock exchanges have risen, corporate and emerging markets spreads have tightened, the ratio of non-performing loans has dropped. According to the Bank for International Settlements, private capital flows to emerging markets have reached the level last seen in 1997, before the Asian crisis. Inflows to European emerging markets have reached all-time highs.
Factors responsible for a sharp increase in capital flows to emerging markets can be divided into pull factors (local fundamentals) and push factors (global liquidity, global cyclical factors). While pull factors actually improved, and rating upgrades by Moody’s outnumbered downgrades by three to one in 2005, they cannot fully account for the magnitude of capital flows to emerging markets in that year. For example, BIS provides a measure of an average sovereign credit rating for emerging markets based on long-term foreign currency Standard & Poor’s ratings. While credit spreads fell to an all-time low, at the same time emerging markets sovereign ratings remained below their highest levels recorded in 1997.
Therefore we may conclude that push factors have been playing an important role in emerging markets. For example, the hedge fund community came to a view that in early 2004 the Polish zloty was an obvious “no-brainer” trade, partly because it had depreciated significantly in previous years and partly because EU accession resulted in a significant and permanent drop in the country’s risk premium. In early 2005, hedge funds were telling me that the Brazilian real was another “no-brainer” trade, as the central bank would have to keep high rates to control inflation and a good external balance indicated that the exchange rate could appreciate. In both cases, the Polish zloty in 2004 and the Brazilian real in 2005 were star performing currencies, and hedge funds pursuing carry trade and momentum strategies were important players on these markets.
Such a situation poses a true challenge for many central banks in emerging markets. They have to judge to what extent their local currency strength is a result of solid fundamentals and to what extent it is just another “no-brainer” trade that may last for quite a while but may also end suddenly. Research conducted at the National Bank of Poland and by other institutions indicates that financial markets have become much more integrated in recent years, global factors drive the performance of emerging market currencies much more than just a few years back, that home bias is being reduced and even a well-known Feldstein-Horioka puzzle is almost gone, ie the cross-country correlation between saving and investment rates has declined markedly.
Favorable global liquidity conditions, attractive rates of returns and good economic prospects draw global investors to Polish financial markets. Additionally, Poland’s accession to the EU and the future entry into the euro area have made the Polish T-bond market, with the average daily net turnover of PLN 6 billion (the largest and the most liquid market in the region), more attractive to foreign investors. EU membership has enabled institutional investors, that are allowed to invest in instruments issued within the Community, to increase their exposure to Polish securities. In 2004, non-residents’ investments in T-bonds issued in Poland rose by about PLN 20 billion, and in 2005 - by a further PLN 7 billion. The beginning of 2006 was also marked by new records on the Warsaw Stock Exchange amid purchases made by foreign investors and domestic investment funds. In 2005, the number of IPOs amounted to 35 and the market capitalization increased by almost 50%.
However, one should not take these favorable global liquidity conditions for granted. Federal Reserve has already raised the interest rate to 5 percent. The ECB is in the process of normalizing interest rates and the Bank of Japan has announced an end to quantitative easing and markets started to price in first increases of BoJ interest rate. This may expose some emerging markets, which have weak fundamentals to a change in investors’ sentiment, may lead to the depreciation of local EM currencies and a significant drop in market liquidity.11 Some risks are also related to the changing structure of our financial markets. Since the second half of 2004, the liquidity of offshore spot zloty market has increased significantly and average daily turnover reached almost USD 1 billion. In addition, high nominal values of single transactions between non-residents contribute to a segmentation of the zloty foreign exchange market. This phenomenon is even more visible in the case of the zloty option market. At the same time the consolidation of the Polish banking sector, transfer of treasury operations to parent banks and very limited amount of Polish banks’ capital, which determines the scope of risk they can take, limits the liquidity of the domestic market.
In the future, financial market for instruments denominated in zlotys could become even more segmented and therefore less effective in absorbing different kinds of risks. This process will accelerate with our accession to the eurozone. Experience of some EMU members, e.g. Finland, indicates that EMU membership will be accompanied by a visible contraction of the domestic market. The introduction of the euro will change banks’ internal organisation of risk and liquidity management. Treasury activities will be centralised on a multi-country group level and proprietary trading will be transferred abroad to head offices.
This process might be accelerated by the already observed transformation of subsidiaries into branches of foreign banks.
Extract from a speech delivered at the Association of Chartered Certified Accountants in Poland on May 18