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2008 Book Reviews

 

When Markets Collide: Investment Strategies for the Age of Global Economic Change by Mohamed El-Erian

Rating:

****

 

(Highly Recommended)

 

 

 

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Transformations

 

PIMCO’s co-CEO and co-CIO Mohamed El-Erian’s new book, When Markets Collide: Investment Strategies for the Age of Global Economic Change, describes the structural changes transforming the world’s economies. Readers can come to appreciate and understand the impact of these changes and consider some ways to mitigate the merging risks of these transformations. There’s great insight on these pages into the bewildering world of finance that has been under great pressure. Here’s an excerpt, pp. 130-133:

Phase 3. Liability and Asset Management

This type of "liability management" has two distinct advan­tages. First, the operations extinguish debt in foreign currency that trades at higher yields than what was earned on the investment of the reserves, thereby reducing the overall nega­tive carry. Second, it helps the country deal with what has been labeled in the literature as "the original sin problem." Coined by Barry Eichengreen of the University of California, Berkeley, and Ricardo Hausmann of Harvard University,19 this concept refers to the inherent financial instability of emerging economies that comes with the currency mismatch that has often (although less so today) been associated with a composi­tion of debt issuance that has favored instruments denomi­nated in foreign currency.

The tendency to issue foreign currency debt reflects not only cost considerations but also a basic reality of develop­ment: Initial risk factors are perceived to be so elevated in some developing countries that there are few buyers out there willing to assume the combination of risks that come bundled in local currency instruments, including credit, liquidity, and currency components. Accordingly, countries face both price and quantity constraints. As such, they are led to issue debt denominated in "hard" currency (specifically, U.S. dollars, euros, Japanese yen, and British pounds).

The issuance of debt in foreign currency provides access to a larger pool of potential investors. It also results in most bonds being traded under U.K. or New York legal jurisdic­tion, which is viewed as more predictable than local laws-although the experience with Argentina's December 2001 default gives some cause to pause. 20

As countries start to run out of debt to buy back, they also focus on "asset management." The objective is to directly increase the returns on the holdings of reserves, thereby again reducing the negative carry. This step is usually associated with a change in mindset: As the reserve holdings increase beyond what is deemed needed for precautionary balance-of­payments purposes, the increment is viewed as de facto con­stituting "national financial wealth."

This phase is usually associated with institutional changes. Most notably, some countries start setting up sovereign wealth funds (SWFs). The seed capital for the SWF comes from part of the reserve holdings at the central bank that are viewed to be well in excess of what would be deemed necessary for pru­dential balance-of-payments purposes. As these SWFs extend their footings, both the media and the politicians pick up on their activities.

As an illustration, consider the recent spike in attention given to SWFs. You would think that the phenomenon was totally new—which is not the case. And you would think that the magnitudes are already gigantic, which they are not (cur­rently amounting to around 2 percent of global financial assets under management). Yet the attention is such as to have SWFs included in the group of "the new power brokers"—a term coined by McKinsey & Company in an October 2007 report describing the growing influence of "petrodollars, Asian cen­tral banks, hedge funds and private equity." 21

Interestingly, the focus of the newly wealthy economies goes beyond assets in the advanced economies. There is also considerable interest in investing in other emerging economies. For example, the SWFs of oil producers have also been exploring opportunities in the Middle East and North Africa, India, Pakistan, and the Far East. As noted in the pre­vious paragraph, Chinese entities have also been pursuing investments in Africa and Latin America, including the Octo­ber 2007 announcement of a $5 billion investment by the ICBC (Industrial and Commercial Bank of China) to acquire 20 percent ownership of South Africa's Standard Bank.

These three phases provide close to a win-win situation for investors in emerging market assets. Virtually any exposure there benefits from the reduction in country risk (associated with the higher holdings of international reserves), the decline in domestic real and nominal interest rates (assisted by the greater availability of capital), and the possible appreciation in the exchange rate. Moreover, the process opens up investment segments that were previously inaccessible, providing investors with the ability to make even larger returns through first-mover advantages. Finally, investors are able to capture the investment premiums associated with the completion of markets and the application of modern portfolio management techniques. These considerations will be highlighted further in Chapter 6 when I discuss how investors can benefit from this age of economic and financial change.

Investors in industrial countries also benefit. The deploy­ment of SWF assets overseas supports valuations in many market segments. And the willingness, indeed necessity, for SWFs to operate in the context of a long-term investment horizon gives them a value orientation when they invest in the more risky segments in the financial system. This was clearly illustrated in the second half of 2007 when several SWFs stepped in to provide capital to ailing industrial country banks and brokerage companies—a phenomenon that attracted significant attention and controversy, which I will address further below.

 

Some readers are likely to go over the 300 pages of When Markets Collide more than once.

 

Steve Hopkins, November 20, 2008

 

 

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The recommendation rating for this book appeared

 in the December 2008 issue of Executive Times

 

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