More Emerging Market Derivative Buying

Yesterday, I pointed out how a recent announcement by the Thai authorities concerning the marketing of derivatives to domestic investors may signal a coming surge in the Thai market.

The phenomenon appears to be wider-spread:

MUMBAI: Overseas investors bought a net Rs 1,380 crore ($347 million) of equity derivatives on September 21, according to figures published by the National Stock Exchange on its Web site.

Open interest, or the number of contracts outstanding in value terms, rose 2 per cent to Rs 66,400 crore.

Overseas funds bought a net Rs 762 crore of shares on September 21 in the cash segment, according to the provisional figures provided by the exchange.

This recent action in South Asia's derivatives markets looks interesting alongside the ruminations of the supposed global credit crunch. For if there really is a shortage of global liquidity, then why are funds buying ultra high-risk emerging market equity derivatives?

The answer probably has something to do with the fact that global liquidity per se is not actually drying up at all. In fact, aside for affected banks in Europe and the U.S., there's a lot of money swirling round the economy at the moment. This is in large part because there is almost nothing in the way of sub-prime debt - which was the catalyst for the crunch - in Asian or indeed emerging market countries. It's worth remembering the generous get-out-of-jail-free cards handed out by western central banks in August.

What appears to be the case is that given the European and U.S. authorities' enormous cash fuels to domestic banks, these banks and funds have started to look for the same kind of gains they were getting from speculating on sub-prime. After all, there is still demand from the hundreds of event-driven funds out there. An obvious contender is emerging market derivatives, which are volatile, but extremely high return. And with emerging market growth soaring this year, the equities possibly look like a good bet.

The scenario is noteworthy because it seems to resemble the mid-90's, when as the American and European industrials took a brief hit, funds piled into emerging market debt and equity, creating another credit spiral altogether (think Mexico, Thailand and Argentina). This was fueled by nothing other than the Fed and ECB throwing money at what should have been a perfectly healthy self-sustaining correction.

The prognosis here is that the extra liquidity supplied by central authorities in the west seems to be being used to gamble for even higher returns elsewhere. If that's the case, then that is a truly global credit crunch in the making.