November 16, 2010 / 11:54 AM / 9 years ago

ANALYSIS-Inflation from QE2 may rein in frontier markets

* Potential inflation from QE2 a danger for frontier markets

* Frontier market flows have lagged, bank lending cautious

* Scope for catch-up in FX

By Carolyn Cohn

LONDON, Nov 16 (Reuters) - The world’s least developed frontier markets could fall off an emerging markets bandwagon as a second bout of U.S. money-printing risks fuelling inflation that may be more damaging to their economies than most.

The larger emerging markets are bracing for a new wave of yield-seeking cash after the U.S. Federal Reserve said earlier this month it would spend $600 billion buying bonds in a second wave of quantitative easing (QE).

Since the Fed unleashed the first round of QE in March 2009, ever-tinier yields on offer in U.S. Treasuries have driven investors towards higher-yielding markets.

But frontier markets, including countries such as those in sub-Saharan Africa, have lagged those gains.

The fast-growing economies of the BRIC countries — Brazil, Russia, India and China — have soared, and huge inflows into local debt have led countries like Brazil to impose capital controls to prevent their rising currencies strangling exports.

The MSCI BRIC index .MIBC00000PUS is trading at record highs after rising nearly 150 percent since March 2009, while the MSCI emerging equities index .MSCIEF has climbed a similar amount and is trading at June 2008 highs.

But the MSCI frontiers index .dMI7400000PUS has risen only 65 percent over the same period.

^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^ For graphic showing relative performance of emerging, BRIC and frontier markets since early 2009, see ^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^^

The Institute of International Finance sees global capital flows to emerging markets at $825 billion in 2010 and $833 billion in 2011, far exceeding 2008 levels of $594 billion.

But for Africa and the Middle East region, which also includes more developed emerging markets like South Africa, forecasts for 2010 and 2011 are $86 and $85 billion respectively — below 2008 levels of $88 billion.

Not only are investor flows looking slower and more cautious towards frontier markets, but the potentially negative impact of higher inflation will be more keenly felt there. “I would view the impact of QE2 as being mostly negative,” said Ahmed Heikal, chairman of Cairo-based private equity investor Citadel Capital.

“QE1 has caused a substantial rise in food prices, QE2 is a continuation of that. There is no sign of food prices abating anytime soon, and that is going to put inflationary pressures on many parts of Africa.” Food inflation is a particular bugbear for frontier markets, as the poor spend a greater proportion of their income on food; for example, bread and cereals make up 25 percent of Nigeria’s consumer price inflation (CPI) basket.

The GCSI agriculture index of agricultural commodity prices, including wheat, corn and soybeans, last week hit a record high, analysts at Capital Economics point out.

As the United States weakens the dollar by printing money, the danger is that oil, priced in dollars, will rise, putting pressure on other industries including agriculture and farming.

“Higher global food prices ... will put further upward pressure on headline inflation in many economies in the coming months, particularly the United States and those emerging economies where food has a high weight in the consumer price basket,” Capital Economics said in a client note.

In addition, banks’ reluctance to lend money — a global malaise — is acute in frontier markets, and these countries are suffering from lack of liquidity.

“Africa is seeing more interest, but particularly from real money,” said Razia Khan, head of Africa research at Standard Chartered.

“It has not had a return of the hedge funds, which benefited from easier liquidity prior to the crisis. That partly explains why frontier Africa has not had the same sort of inflows that other emerging markets have seen.”

Frontier African currency strength has not been as evident as in countries like South Africa, Khan said, even though African markets are not bound by stringent capital controls.

A further round of QE is likely to draw more money into African currencies and debt, but inflows need to happen quickly so that inflation does not dent Africa’s growth prospects.

“The danger for African countries is if you see oil prices going a lot higher — or food prices — before you see African currencies rising,” Khan said.

But some investors say frontier markets will inevitably benefit from the thrust towards higher yielding assets.

“If you pull a sheet from the middle, the top countries like BRICs move ahead first, the rest get drawn up with that,” said David Creighton, president of Montreal-based emerging market fund manager Cordiant Capital.

“We see real opportunities in frontier markets.” (Graphic by Scott Barber; Editing by Catherine Evans)

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