Emerging Market Merry-go-Rounds

Paul Kedrosky writes about one of my favorite topics, emerging market decoupling. He cites a new report by HSBC which discusses a "global monetary merry-go-round":

Our optimistic views on the emerging world are also based on what we call the monetary merry-go-round. Low US interest rates typically encourage capital to flow into the emerging world. Attempts by emerging nations to limit the resulting exchange rate appreciation lead to offsetting capital outflows in the form of rising foreign exchange reserves which are often invested in US Treasuries. Higher demand for Treasuries keeps yields low and, hence, leaves US interest rates low, thereby allowing the merry-go-round to repeat, seemingly ad infinitum.

The merry-go round leaves the global cost of capital too low.  A hunt for yield develops. Before the credit crunch, this hunt led to huge investments in mortgage-backed securities which, in turn, fuelled the US housing boom. Post-credit crunch, however, the hunt for yield has gone elsewhere. Investors are now keen on the emerging nations with their strong secular economic prospects.

The implications are simple. Emerging currencies will be under upward pressure, their asset markets should appreciate and their sources of growth should switch from exports towards domestic demand, thereby helping to narrow their, in some cases, large current account surpluses. Indeed, the EMI shows that total order books are rising at a faster pace than exports, supporting the view that recoveries are domestically-led. 

Paul is skeptical about the idea of decoupling. China's consumers cannot fill the consumption void in the absence of social safety nets. I would add that this "too low" cost of capital is having an additional effect of stoking inflation fears (exhibited by the recent surge in gold prices).

Although we may be in the recovery period, no one can seem to figure out the best place to put their money.