The BRIC Temptation

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My final posts on Crisis Talk addressed issues concerning capital flows and emerging markets (see here and here). As most of the world emerges from the crisis, the demand for 'safe' investments, such as American and European government bonds, has diminished. This has been exacerbated by negligible interest rates in mature economies, which generate low investment yields and inexpensive lending. As Nouriel Roubini observed, this is the perfect recipe for borrowing cheaply in dollars, and investing outside the United States, primarily in emerging markets. This is likely to go on for some time: dollar depreciation continues to look like a one-way bet, and the Fed has indicated that low interest rates are here to stay.

Meanwhile, emerging markets have gone from strength to strength. China is leading the world out of the worst financial crisis since the Great Depression. Brazil is increasingly feted as one of the Western Hemisphere's most dynamic economies, with a diverse economic base ranging from aircraft production to vast hydrocarbon reserves. India has emerged from the crisis relatively unscathed. Even Russia, long considered by many as the black sheep of the BRICs, is looking up. Oil prices are on the rise (and may get much higher), while the rouble has been the best performing major currency against the dollar since the start of September.

Yet, I can't help wondering if this is all too good to be true. To me, the question isn't, "are emerging markets overheating?" Rather, I tend to ask myself, "to what degree are they overheating, and what risk (if any) does this exceptional growth pose to the global economy, particularly as it emerges from the crisis?"

One issue of concern is the inability of central banks and governments to control capital inflows. Brazil's recent attempts are failing. The same is true for India. If commodity prices continue their strong rebound, we may see a renewed enthusiasm for Russia and the Gulf (property prices in Dubai are beginning to recover; Russia spent $700m yesterday selling roubles). World Bank President Robert Zoellick today expressed concern of overheating in East Asia.

Yet, there may be little that governments can do to control these events, particularly if the investment prospects in other markets remain dim. Thus, we are left with a situation where we are faced with irrational investor exuberance coupled with clipped government wings.

This may not be the recovery we had been hoping for.

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