LONDON -- Liquidity in emerging markets is poised to slump to its lowest level in five years, raising concerns among plan sponsors that sharp volatility in asset prices at the end of the year will adversely affect their 1999 performance figures.
Investors also are concerned that reduced liquidity will increase portfolio risk should there be further sovereign defaults or currency problems among emerging economies.
Analysis of portfolio flows in assets held in custody by State Street Bank, Boston, shows trading activity in emerging markets has dwindled sharply during the past eight months, touching a five-year low in July.
Liquidity eased slightly during September and October, but plan sponsors and money managers expect it to dry up rapidly from now until early January as market players become increasingly unwilling to trade.
A large part of the slump is due to fears of the impact of technology problems related to the so-called millennium bug, according to Avinash Persaud, head of global research for State Street.
Liquidity also has fallen sharply in the past year as there are fewer market makers trading stock. Last year's crises in Russia and global credit markets saw many banks close down their proprietary trading desks, which had been an important source of liquidity.
"I don't have a good feeling in my stomach about this. Proprietary traders will close their books during the last five to 10 days of this year, which means there will be zero liquidity," said Franz Winkler, portfolio manager for the Swiss pension fund Pensionskasse Schweizerischer Elekrizitatswerke, Zurich.
He is concerned hedge funds might step into the vacuum and attempt to push the market with relatively small amounts of money.
"It's a self-fulfilling prophecy. As everyone gets worried liquidity will dry up, they pull back from the market, and liquidity dries up anyway," said Bill Muysken, head of global manager research for William M. Mercer Ltd., London.
Pooled fund managers such as Barclays Global Investors and Legal & General Investment Management Ltd. have announced they will reduce their dealing days during the Christmas and New Year holiday periods. They want to avoid managing cash flows when the market could be subject to high volatility and dealing spreads could widen sharply, said Mr. Muysken.
And plan sponsors are putting off making manager and portfolio changes until January on fears that asset prices will be distorted by a lack of liquidity, according to Ken King, managing director at Rexiter Capital Management Ltd., London.
"Our advice would be if you are about to fund a new portfolio of emerging market assets, wait until the New Year," said a U.K.-based consultant who did not want to be identified.
Many funds are concerned that performance figures for the year could be distorted by year-end volatility. Actuaries have latitude to adjust and smooth performance figures to take account of unusual factors, but "we might get some odd numbers for the December quarter," said Mr. Muysken.
"Our board is aware of the problem and realizes that we cannot influence the performance over the last few days of the year," said Mr. Winkler.
Rather than flocking into cash, plan sponsors and money managers are simply holding their positions in emerging markets until early January.
Bert van Baelen, financial assistant to the Belgian pension fund for doctors, dentists and pharmacists -- Voorsorgsjas voor Geneersheren, Tandartsen en Apothekersin -- in Brussels, said the Y2K computer problem is an issue for all of the fund's portfolios, and few of the plan's managers expect to do much trading during the first few weeks of January.
But the E450 million plan is maintaining its current positions of 2.5% and 10% of the fund invested in Latin America and Asia, respectively, he said.
"We have a strict policy to be fully invested. As far as we are concerned it is the manager's responsibility to make sure that the companies we are invested in have checked their (Y2K) compliance," Mr. van Baelen said.
The U.K.-based consultant said many clients were, like VKG, leaving their investment managers to decide whether to increase the cash holdings of their emerging market portfolios.
State Street's Mr. Persaud based his analysis of liquidity in emerging markets on portfolio flows in the $5.3 trillion of assets held in custody by State Street. The indexes of liquidity in buy and sell transactions were calculated by measuring the price movement that takes place in an asset when it is bought or sold. The index is plotted on a graph with 1.0 indicating the greatest liquidity over time and 0 the least liquidity.
"The fact that liquidity is falling in both buys and sells at the same time indicates that liquidity is being siphoned off by Y2K fears," he said.
He also is concerned that the risk of contagion among markets has increased as investors are trying to reduce their long positions across all markets, irrespective of the underlying fundamentals.
