I recently read a simple but powerful idea about how the hot money really affects emerging markets. At some level the well informed people tend to know this. But the actual numbers put together make it quite stark.
The emerging market cap as % of total global m-cap is less than 10%. India in particular is not more than 2-3% if I am not mistaken. Now, the world has been a quiet place for some time now (financially speaking). And post 9/11, on account of two factors, global investors have been more courageous in investing.
First of these is the slowdown or lacklustre performance of developed markets - especially US and Japan. These markets are not only giving very meager returns, they also seem to be structurally stuck to a sub-10% returns regime. Coupled with this, the investors are increasingly more organized in the form of mutual funds, pension funds, hedge funds - across all sections in individual and institutional domain. This has led to a hunt for more attractive returns. The traditional fears of investors were overcome by the other strong motivator of greed and they looked increasingly to the emerging markets - mostly in east Asia. Add to this the perpetual money mining machine of Japan which is churning out low cost funds without a very strong appreciation of its currency. Last but not the least is the emergence of petrodollars in every rising quantities. Considering the fact that oil production costs have not gone up by anything close to the appreciation of oil price, one gets a sense of enormous rents that the producers are collecting. The money needs to go somewhere and it is as much on the prowl for good investment opportunities as is the Japanese and American money.
Second factor is the relative stability and robustness of growth stories in the emerging markets. China has never looked better and now has 20 years of performance record to back it. India is looking like the next China (in terms of growth rates - not much in the details of growth drivers), South-East Asia looks like it has recovered mostly from the 1997 crisis and buoyed by oil price, Russia is not a bad idea either. There are of course numerous others which have been rediscovered including East Europe, Australia, Turkey, Brazil, Mexico and the like. Point is - the emerging markets have never looked better than this.
Bottomline: There is a lot of money looking for good investment opportunities outside of their home country and then there are lot of good investment stories around the globe.
So far so good, but there is a catch in the details. The relative sizes of these two domains - developed markets and emerging markets - are quite different. As mentioned above, emerging markets are a small fraction of the developed markets in terms of m-cap. In new asset classes like real estate, the skew is even starker.
This leads to the scary prospect of hot money wrecking the markets in a crisis. Picture this. In India, the listed companies post a good profit year after year and look like they are going to continue their good run for a while. The economic fundamentals are sound and the country looks a good investment story. The global investors flock to India and invest say 5% of their portfolios in India. This however, amounts to as much as the the existing market cap of Indian companies. Thus the inflow ends up doubling the sensex over 3-4 years. All good!
The trouble comes when there are signs of slowdown. A global crisis - US attacking Iran or another 9/11 or BoJ increasing interest rates - may reduce the risk appetite of investors who would look to pull out of risky securities and park money in the safe havens - gold, (oil futures!), US bonds, US Bluechip stocks et al. The same 5% that entered the country (or a good part of it) would want to leave. Yet again, it would be nearly 50% of the total m-cap (or 30%, but large nevertheless). The markets would tank for no obvious reason (at least internally or fundamentally). Infosys might grow a bit slower and HLL may sell a bit fewer soaps - but their profits would not fall by anywhere near what the valuations would fall by. Why? Because though the fundamentals of the economy remain strong, the investors have chosen to reprice risk and thus now prefer to stay out. Also they want to stay out of risky assets till the storm withers away! They will come back with as much or money to invest once it settles down a bit.
The problem is that they will again bring money enough to double the sensex. And the cycle would continue till such time Indian market becomes say 10% or more of the global market.
Think of it like this - your financial advisor tells you that you should invest in mid-cap mutual fund given your risk profile. You do so. Then election year appears and things look a bit shaky. Your advisor is back and is now telling you to hold off more investments in mid-caps and in fact reduce the existing exposure as well. You would see the logic of this very clearly. And in a similar manner, the global investors agree with their advisors when they pull out of or invest in emerging markets. We - in India - are the world's mid-cap!