Hot Stuff (Overheating E.M.)

July 5, 2011

The Economist has an interesting piece out asking “which emerging economies are at greatest risk of overheating.”

They explain the six factors that go into their “overheating” index:

  • inflation
  • GDP growth
  • unemployment
  • credit growth
  • real interest rates
  • change in current-account balance

With 100 representing “maximum risk,” Argentina tops the charts.

But the other members of the sizzling seven — Brazil, Hong Kong, India, Indonesia, Turkey, and Vietnam — aren’t far behind.

The Economist’s findings are in line with our “E.M. Hiking Cycle” theme, wherein high profile emerging market nations are forced to raise interest rates in the teeth of inflation.

What are the ramifications of a hiking cycle as things get too hot to handle? That’s where things get tricky.

Some foresee a scenario where Western currencies and bonds weaken dramatically in favor of E.M. denominated assets, with even more capital flowing into economies like Brazil’s.

This would be a negative for the $USD — and potentially the euro too — as global investors focus on not just interest rate differentials but creditworthiness.

The picture may not be so simple, however, as too much capital chasing E.M. assets could accelerate the very overheating that is hoped to be prevented.

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That in turn could lead to (1) too-strong currencies choking off exports or (2) a slam-on-the-brakes emergency response, followed by some form of meltdown.

The other $64 trillion question being this:  How decoupled are emerging markets, really and truly, from a weak U.S. economy in a post-stimulus environment?

And what kind of aftershocks would a China hard landing have?

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One Response to Hot Stuff (Overheating E.M.)

  1. MBMB on July 5, 2011 at 3:33 am

    The conclusion may seem right but the index is seriously flawed. These six variables are not only
    extremely correlated and that they will all be moving in perfectly predictable directions due to the
    high correlation amongst them. Yet there is more to it as there is a causal relationship between them
    which very much defies the logic of index construction. Correlated variables
    have to be properly transformed and orthogonalized in order to serve as components of an index.
    That is apparently not what the they did came up with and the index as such is
    seriously flawed . It could at best serve as an indicator of economic activity,
    but a poor indicator nevertheless due to the orthogonality.

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