Unreaching for Yield
India’s rupee has fallen to a new low against the dollar, despite vigorous intervention by the Indian central bank. This is part of a broader trend in emerging markets, as money heads back to the markets that have…er…already emerged.
For the past several years, rich-world central bankers have been nursing their economies along with loose money and low interest rates. Yields in the U.S. and Germany were further lowered because the unsettled global financial climate made investors unusually interested in “safe” investments -- read, “U.S. and German government bonds.”
However, rich-world investors had another, almost equally urgent imperative: preparing the aging populations of those countries for retirement. With returns crashing on those safe investments, and the stock market hammered by waves of instability, institutional investors such as pension funds were in a pickle. They needed their investments to deliver cash at a pretty robust rate, because that’s what their projections called for; if they fell short, they would have to make an unpleasant demand for top-up contributions. But as the bonds in their portfolio matured, they were getting a chunk of cash that could only be invested at a significantly lower rate. Endowments and other institutional funds faced related issues. And even in the rest of the market, there was considerable competitive pressure to deliver higher returns than you could get by putting it in T-bills -- which themselves weren’t delivering much more return than your friendly neighborhood mattress.
Institutional investors were thus forced -- or at least strongly incentivized -- to “reach for yield.” Which is to say, they took on more risk to get higher returns. This was perhaps not great for the pensioners whose money they were risking, but it was great for emerging financial markets.
Now that process seems to be reversing itself, as the rich-world economies begin to recover, and Ben Bernanke begins to contemplate tightening the monetary taps. Emerging market central banks can't necessarily do anything to halt the process. India has certainly given it the old college try, to little effect.
Obviously, this is not good news for anyone in an emerging market who is trying to borrow money or buy imported goods. But it is good news for the people who depend on rich-world institutional investments. Foreign money is frequently stupid money -- which is not to say that the people investing it are stupid, but rather, that being far away, they never have as much information as the locals. Given that fact, even in a well-run, stable emerging market, foreign investors are always taking on more risk than they would at home. That risk is a healthy part of a balanced portfolio -- I have about 30 percent of my retirement funds in international. But it’s best if that’s a considered decision, not something you’re forced to by slumping returns at home.