Chinese Charades

The Stalwart has an excellent explanation up of the over-heating of Far Eastern emerging equity markets in light of institutional  funds which have promised investors continual investment in these markets no matter what the cost:

But then you have to remember that once again, when money is allocated to funds which have a strict mandate, it needs to be invested no matter what. Thing is, who says these countries have enough listed companies in order to accommodate this sudden shift in funds? Perhaps they're already fully valued. Perhaps an emerging market is only US$200bn in total. What then happens when suddenly a few billion dollars needs a home within 6 months?

Basically, one has to imagine that fund flows can change in magnitude by large, say 20%, increments per year. But on the flip side, an economy can supply only so many new businesses for sale per year. Economies build value in smaller, more steady increments. Without a boom of truly valuable IPO's, we're asking for trouble when suddenly a ton of americans decide they need a re-allocation to Asia. The result? Expensive emerging market stocks get bought just because they have to be and get ever more expensive. Small market + big foreign flows mandated for rapid allocation = bad companies in volatile economies rise to valuations at or above larger, stronger, more stable ones back in the US.  You pay the portfolio manager big bucks to be smart, but then he is forced to just invest along a mandate and buy his index.

This is an exact replay of what happened pre-1997 in Asia, except that time round it was in the private equity sector. In the early 1990's funds began promising multi-millions of dollars returns by buying into South East Asian (and in particular Chinese) private equity, only to find that most of the equity just wasn't there after they had found a place for the first 10% or so. The private equity funds were then forced into commiting their capital at no matter what cost. Instead of turning the funds away empty-handed, emerging economies made the situation worse by manufacturing private equity deals which could be legislatively contsrued as reasonable private equity investments, but which were in fact, not worth the paper they were written on.

China's continued encouragement of foreign investment should sound warning bells to anyone thinking of joining the Eastern rush at this stage, for this time round, the situation is potentially more perilous. Since this is publicly tradeable - and therefore quoted - equity which is being sold hard to emerging market investment funds, it adds another dimension to the boom-bust factor. At least last time round there was a limit to how much private equity could be sold to foreign funds before the game was up and investors realised what they owned was worthless, since there is no speculative capital gain to be derived from private equity unless you can source another buyer. In the case of this publicly tradeable equity however, funds are showing worthless paper capital gains on these foul investments, giving investors in the funds the impression that performance could not be better, and this in turn only encourages more good money to follow the bad.

Of course the governments of these emerging economies are only too aware that as long as they keep encouraging more foreign investment into the region, the game is not up. Unfortuneately for foreign investors, the longer this charade goes on, the more are going to feel even heavier consequences.