Threats Grow in Developing World

Threats Grow in Developing World

By PETER STEIN
Could emerging markets experience a "black swan" moment?
In recent weeks, a steady flow of global capital into emerging markets has picked up pace as investors flee weak Western economies with their rock-bottom interest rates in favor of the growth potential in the emerging world, especially in Asia. Of the more than $60 billion in net inflows into emerging-market equity funds so far this year, $23.3 billion, or more than a third, has jumped in just since the beginning of September, according to EPFR Global.

The question is, could something unexpected happen that wrongfoots the market—either a "black swan" event that completely surprises investors with a rare and highly disruptive outcome (a coup in North Korea, say), or even just a bout of short-term turbulence that rocks global markets?

There are, of course, good reasons why money is flowing from the developed world into the developing one. The pace of growth and relatively low debt levels in economies like China, Southeast Asia and Brazil offer huge promise at a time when the overly indebted economies of the U.S. and Europe are being forced to deleverage.

Many investors, however, are betting not just on growth, but on surging asset prices stemming from a giant inflows of easy money. Stock prices in much of Asia have already been rising on expectations of further moves by the Federal Reserve to stimulate the limp U.S. economy with more "quantitative easing," purchases of Treasury bonds aimed at pumping more cash into the financial system. Fed Chairman Ben Bernanke's comments Friday in Boston did nothing to dispel those beliefs.

A lot of investors "expect this great bubble that they're all going to make money in," says Russell Napier, a strategist with CLSA Asia-Pacific Markets. He believes it's likely Asian governments overwhelmed by the inflows and unwilling to let their exchange rates rise too quickly against the dollar will resort to capital and credit controls that could deliver a market jolt.

Some signs of that scenario are already popping up. This month, Brazil doubled a tax on foreign investment in certain Brazilian bonds. In Thailand, authorities last week imposed a tax on foreign purchases of Thai bonds and may take other measures to rein in speculative investments from overseas.

So far, markets have taken those moves in stride. But it's possible some government battered by a wave of foreign money could overdo it, as they've done before.

In December 2006, Thailand, trying to restrain the rising baht, announced that foreign investors in Thai stocks and bonds would have to deposit 30% of the value of their investment in a noninterest-bearing account with the central bank for at least a year. The country's main stock index fell 15% in a day, wiping out $22 billion in market capitalization, and other emerging markets fell, too. The authorities quickly reversed themselves on some of the curbs, though others were kept in place for another 15 months.

Other risks lie in the U.S. Frustration over China's currency policy, for example, could lead Congress to impose sanctions leading to an all-out trade war.

"If you are an investor in the emerging world, watch what is going through Congress," says Paul Schulte, a strategist at CCB International Investment Ltd. in Hong Kong. "If you see trade bills that are harmful gathering momentum, get out." Of course, when everyone wants to get out at once, these markets often can't accommodate.

Sean Darby, a strategist at Nomura Holdings Ltd., remains wary of U.S. policy risk, too. He remembers during the financial crisis when Congress failed to pass measures that the markets already assumed had been agreed on. "I was scarred by those experiences, going to bed thinking something was a done deal and waking up to find out it had gone the other way," he says.

Yet even amid proliferating references to "currency wars" in the news, volatility in Asian stock markets is at new lows, according to Deutsche Bank. That makes it relatively cheap to place a bet that the status quo will be disrupted in some way that the market isn't accounting for.

One way to do that is through what's known as a straddle, in which an investor purchases both put and call options on a market index. A straddle is a bet on volatility, as it makes money if a market moves sharply either up or down. (A put option allows an investor the right, but not the obligation, to sell securities at a specified price within a certain time period. A call option allows the investor the right to buy securities under similar conditions.)

Brad Jones, Asia investment strategist at Deutsche Bank, says an "at the money" straddle of the main South Korean stock index currently runs about 7%. That means that for $70,000, you get exposure to $1 million worth of the index. And if the stock market either goes up or down by at least 7%, you make money.

"Your maximum gains are unlimited if the market trends in either direction," he says. If the market goes up or down 20%, you make 20% of your exposure minus your cost—that is, $130,000. Of course, if the market doesn't go up or down 7% before the straddle expires—in three months, in this example—you lose your $70,000.

Given the low cost of this insurance at the moment, "I don't think you need to have a 'black swan' type of view to think about buying some level of protection," he says.

Nor do you need a negative view on long-term emerging-market prospects to believe there's money to be made betting against the herd rushing into these markets in the short term.

Write to Peter Stein at peter.stein@wsj.com