Capital flows to emerging markets have risen to $825 billion as a result of the ultra-low monetary policy in rich countries. They are running the risk of destabilising these markets

The global economy is like a balloon. If you push in one place, it will bulge out somewhere else. This is what is occurring from the flood of money coming from Japan and the United States. The quantitative easing and ultra-low interest rates in both of these countries might be good for the local economies, but they could have negative effects on other markets, specifically emerging markets.

Net capital flows to emerging markets have turned into a torrent. According to The Institute of International Finance, the capital flows to emerging markets have risen to $825 billion as a result of the ultra-low monetary policy in rich countries. With meagre yields in their own countries, great herds of investors are migrating across the global plains in a frantic search for yield. They are running the risk of destabilising these markets. The amount of capital flows into Asian and Latin American markets have already exceeded the last peak in 2006-2007 with inflows into Asian economies 60% above the prior level. Research by the IMF has shown that in the past monetary easing has transferred itself almost completely to emerging economies regardless of their economic circumstances.

The effects of this carry trade can be seen around the world. For example in Indonesia the stock market is up 46% for the year, which makes it the best performer in Asia. The Thai stock market has also done well, which is surprising considering that the country has been wracked by weeks of antigovernment demonstrations and political unrest. In Hong Kong, where the currency is pegged to the dollar, the US monetary easing has helped create a real-estate bubble. The residential property index is up 46% this year. In Peru the local currency, the sols, hit a two-year peak against the dollar, shares are up 33% and foreigners have increased their investment in local currency denominated bonds to over 20%.

Some investors like to attribute this froth to the vibrant economies. Goldman Sachs has projected that the total capitalisation of emerging markets will inevitably rise from $14 trillion today to over $80 trillion by 2030 translating into an annualised return of 9.3%. While such projections always have an air of inevitability, the problem with all economic projections is that at some point of time, they will be wrong. A recent Asian Development Bank report forecasts that South Korea's long-term economic growth will fall from an average of 6.3% to a baseline projection of 3.9%, Taiwan's from 6.1% to 3.1%, Indonesia's from 4.8% to 4.4% and India's from 5.5% to 4.5%.

The rise of emerging market economies does not necessarily translate into profits for investors. According to a study of 17 national stock markets since 1900 by London Business School, there was no correlation between an individual country's GDP growth and returns to investors. If an economy is growing, it means that someone is making money, but it does not mean that an investor and especially a foreign investor will do as well.

In fact the present rise of emerging markets might remind some older folks of a different time. For example the Thai baht has risen to levels not seen since before the Asian financial crisis hit in 1997-98. The same is true for the Malaysian ringgit.

Prior to the Asian financial crisis vast amounts of foreign capital poured into what were then known as the Asian Tiger countries. These flows made up to 17% of Malaysia's GDP in 1993 and 13% of Thailand's in 1995. When the bubble collapsed, markets in Thailand, South Korea, and Malaysia - all had losses of at least 60% in dollar terms. This is not to say that the economies in emerging markets in 2010 are plagued with many of the problems that they had in 1997. These economies have learned painful lessons from that crisis. They have built vast reserves of foreign currency and substantially strengthened their banking systems. Still, these markets are small and volatile.

As the Asian crisis showed, they are also subject to dramatic capital controls. Recently new capital controls were put in place in Indonesia, South Korea and Taiwan. These capital controls are reminiscent of the capital controls instituted during the Asian crisis when Malaysia overnight without warning slapped capital controls on foreign investors.

Many of these economies have a recent history of excellent financial management. They easily survived the recession and are blessed with excellent growth. This prudence should be rewarded with rising markets, but recent rises and valuations are unprecedented. The sad part is that the global economic distortions caused by their larger neighbours' massive fiscal and monetary stimulus has created an economic experiment on a global scale that has the potential of creating havoc in smaller markets when the inevitable corrections occurs.   

 (The writer is president of Emerging Market Strategies and can be contacted at [email protected] or [email protected]).