The long, dark shadow of the Mexican Peso crisis cast itself over the emerging market universe in 1995 like some sinister ghoul, frightening away investors and sending many of the dedicated managers scurrying into the distant, unfamiliar corners of the investment world: Africa, the Middle East and Russia.
For some, however, the crisis in Mexico was an unexpected boost. Just ask Steve Hanke, Professor of Applied Economics at Johns Hopkins University, Forbes columnist, advisor to Argentina’s Minister of Economy, President of the best performing Emerging Market fund for 1995 (Toronto Trust Mutual Fund Argentina), which was up at a stunning 79.25%.
The investment policy for Toronto Trust Argentina was laid out in Hanke’s Forbes column in December 1994, just prior to the Mexico crisis. Hanke identified that understanding a country’s monetary policies is crucial to getting right timing in emerging Markets investing. Key to this is understanding a country’s exchange rate system.
There are three types of exchange rates – floating, fixed and pegged. The floating exchange rate, which is used by the US and by most major currencies, is not used in Emerging Markets, but both the fixed and the pegged are, with the latter being prevalent. Fixed and floating systems are free-market mechanisms, limiting a governments’ control over the currency, whilst a pegged rate is an interventionist tool, decreeing that the central bank must manage the exchange rate, liquidity and the capital account. Hanke cites this as a near impossible task, and warns investors to pay the most careful and anxious attention to pegged exchange rate systems.
The markets considered Argentina’s currency-board as high risk, even before the crisis in Mexico. For the Toronto-based Friedberg Mercantile Group, which manages Toronto Trust Argentina and where Hanke was Vice-President, the picture was somewhat different. Hanke’s thorough understanding of the system, gained from within, suggested a different scenario. Whilst the rest of the market thought Hanke and Friedberg to be not entirely serious and ultra-optimistic, the company started to make its investments.
Friedberg’s basic premise is this – once the exchange rate is absolutely fixed, interest and inflation rates in a currency board country will start to converge towards those in the anchor country currency. Inflation in Argentina was indeed falling, ending in 1994 only just above the US rates. Interest rates, however, were well above those in the US. Peso-denominated T-bills were yielding around 10% and 7-year paper yielded 16.75%. Comparable rates in the US at the same time were just over 5 and 8% respectively. The differences can occur for a number of reasons – for international investors, the total cost of investing in Argentinean paper was higher than for US bonds, and perhaps more importantly, Argentina’s credibility as a debtor was somewhat below that of the US. However, Hanke and Friedberg considered that the differences in yields between the US and Argentina were unjustified and, that Argentinean debt securities were, hence, a very interesting prospect.
Then the Mexican Peso was devalued, and most of the rest of the world sought to liquidate Argentinean peso holdings. By March 1995, panic selling was nearing a peak and yields were as high as 46% on some paper. The world, and its dog it seemed, was selling while Friedberg was buying. Whilst the world saw collapse and disaster, Hanke saw greater opportunity – ‘the rest of the market got it wrong’.
So why was there almost unanimous misconception? How could experienced traders and managers from the rest of the world miss such an opportunity?
Hanke cites his and Friedberg’s experience as currency traders as a core reason. ‘This gives us a better understanding of the market than many other players. Half way through 1995, nobody foresaw that an Argentinean fund would be top of the pile at the year end, but this ‘anomaly’ was predictable. It just requires knowledge of the system’, argues Hanke.
Indeed, on 17 January 1995, Argentinean Finance Minister Cavallo recruited Hanke as an official advisor, to explain to the world how the currency-board worked. ‘But was anybody really listening?’, asks Professor. It seemed to Hanke, that the international players took his optimism with a large grain of salt. ‘People who I spoke with, and who obviously thought I was a bit off-the-wall, would later ring me back and say ‘you were right all along’, but they still would do nothing about it.’
Emerging Markets, more than developed ones, are rife with rumors and hearsay. ‘I have known Menem [Argentinean President] since 1989, and I knew that the rumors that Cavallo was going to be sacked, or resign, were nonsense’, comments the Professor. To reinforce this, Hanke and his wife Liliane interviewed Menem for Forbes magazine in September 1995. It ended with Menem’s assertion that Cavallo would stay with the government ‘until 1999’. Obviously, fund managers do not believe everything they read in the press.
‘People do not always seem to pay attention. The market’s perception was completely out of line with reality. A fantasy land’, Hanke continues. He is also a little critical of some of the less experienced players, predominantly from London and New York. ‘They are too much influenced by the Argentines, who, given Argentina’s propensity to shoot itself in the foot, have become rather pessimistic.’
Friedberg, because of their own knowledge of the market, did not succumb to this negative local bias. Coupled with a rather superficial understanding of currency markets, especially the fixed-rate currency board system, it was the influence if this local pessimism that kept most of the big foreign players out of the Argentinean debt market.
Hanke notes that ‘more people are realizing the strengths of Argentina now’. This does, to some extent, reinforce Hanke’s view that the competition in 1995 was ‘too hesitant, too slow and too reactive. Our knowledge of the system helped us to anticipate developments, and get our timing right.’
With interest rates in Argentina falling in 1996, liquidity rapidly increasing, and the economy likely to grow by 5% in real terms (Hanke considered it may do even better) and profits returning, Friedberg was now looking seriously at equity investment. Already, they hold 10% of the fund’s portfolio in convertible debentures, and the first straight equity investments will probably follow shortly. Prof. Hanke re-iterates the advantages of knowing the currency markets. ‘If you do not understand the currency situation, you can get clobbered. You will therefore get your buy-sell timing wrong, and you will only react, not anticipate. We succeeded in 1995 because we anticipated the situation. Mexico just made things better.’
At Friedberg people are, according to the Professor, currency specialists first, country pickers and portfolio allocators second. ‘If you get the country right, and you know now much to allocate to bonds and equities, individual stock selections are not always vital. Obviously, if you just pick the dogs, you will not get anywhere. But, if you get the currency right, then the stock selection will be less important.’
‘Ultimately, victory is often not being overwhelmed by the opposition’, Prof. Hanke muses, quoting the Duke of Wellington.
The article was kindly provided to us by Expat Capital - one of the largest independent investment and asset management companies in Bulgaria. Based in downtown Sofia, the company offers asset management and financial advisory services. The company has a wholly-owned licensed asset management subsidiary, Expat Asset Management, with several mutual funds and lots of individual investment accounts for a select group of clients. As of April 2012, the Expat assets under management are over EUR 28M.
Steve Hanke is an American economist specializing in international economics, particularly monetary policy, named to be the father of the currency boards. He is a Professor of Applied Economics at The Johns Hopkins University in Baltimore and a Senior Fellow at the Cato Institute in Washington, D.C.
Image courtesy: Chris Ford, 2012, Flickr CC.