Emerging Markets Are on Their Own; Things are looking ugly for countries that have delivered about 75% of global growth over the past decade.

June 23, 2013, 8:28 p.m. ET

Emerging Markets Are on Their Own


It is high time investors demerged emerging markets.

Protests on the streets of Brazil and Turkey, a cash crunch in China’s financial system, strikes in South Africa: These all indicate rising stress in developing economies. Add in signals the Federal Reserve may soon scale back its bond-purchasing program, and things are looking ugly for countries that have delivered about 75% of global growth over the past decade.

After a decade or so in which emerging markets reliably juiced the global economy, this is a wake-up call for investors.These countries vary in terms of economic and political development. Protesters in different places have particular grievances, from Brazilians facing higher bus fares to Turks fearing the destruction of a park.

But since the turn of the century, investors increasingly have treated emerging markets as a single asset class, collectively borne aloft by favorable trends, such as China’s emergence into the global trading system.

Concepts such as the Brics countries—originally Brazil, Russia, India and China, later joined by South Africa—cemented the idea that developing countries could be treated as one.

Such ideas proved rewarding: Emerging-markets stocks, foreign exchange and credit returned 19%, 6.8% and 11%, respectively, from 2003 to 2010, compared with a 4.1% return for the Standard & Poor’s 500-stock index, according to Goldman Sachs GS -0.75% .

The supportive tailwinds are slackening now, exposing underlying weaknesses.

Take exports. Selling goods to credit-fueled developed countries helped emerging markets narrow their trade deficits and boost employment, especially before the global financial crisis. But this dynamic has stalled. The preliminary reading for new export orders on the HSBC HSBA.LN -0.82% Markit purchasing managers’ index for China fell to 44.0 in June, with a reading below 50 indicating contraction.

Clearly, Europe’s moribund economy is hurting trade. But even the relatively sustained recovery in the U.S. is proving less helpful than expected.

As UBS UBSN.VX -1.46% strategist Bhanu Baweja points out, recent growth in the U.S. has centered on industries such as construction, autos and energy. These are sectors in which the U.S. is either pretty self-sufficient or reliant more on countries like Germany for supplies. There is less robust demand for products like electrical goods, 11% of all emerging-markets exports, or clothing, which accounts for 4.2%. This has weakened the usually strong link between U.S. and emerging-markets growth.

China’s Janus-faced position has exacerbated emerging nations’ problems. Like its peers, it gained when exports to developed economies were strong. Its own investment boom, meanwhile, juiced commodities prices, which benefited those nations that export them, such as Brazil. Now, China’s growth is slowing and Beijing wants to curb the economy’s reliance on fixed-asset investment.

Slower growth forms the backdrop to rising popular discontent. Turkey’s gross-domestic-product growth rate was 2.5% last year, down from 9.2% in 2010; Russia, which saw mass protests last summer, has seen growth slow to 3.4% from 4.3% in 2010 and 2011. Brazil’s also slowed sharply in the same period. The International Monetary Fund just cut its Russian growth forecast for this year from 3.4% to 2.5%.

The unrest suggests governments didn’t do enough to tackle underlying problems during the good times. All of the Brics countries have fallen in Transparency International’s Corruptions Perception Index in the past decade. And while labor productivity growth for emerging countries remains faster than for their developed peers, the gap has narrowed in the past three years, the result of a slowing pace of economic overhauls, Mr. Baweja suggests.

Data on inequality are less conclusive. The Gini coefficient measures wealth disparity. In Brazil, it fell to 0.51 in 2011 from 0.55 in 2004, according to the Socio-Economic Database for Latin America and the Caribbean, indicating the gap between rich and poor narrowed. But that is still well above the average of about 0.3 for members of the Organization for Economic Cooperation and Development. The problem for countries like Brazil is that when times get tougher, disparities come into sharper focus. That raises political risk premiums, which fell through much of the first decade of this century.

Already, since 2011, emerging-market stocks’ annualized return has declined to a negative 6.3%; for foreign exchange, it is now a negative 0.8%. Credit has remained relatively buoyant, up 7.3%. Still, the S&P 500, with a return of 12%, has outgunned them all.

Rising Treasury yields will exacerbate this trend by pulling more investor dollars there even as developing countries that have become reliant on external financing, notably Turkey and South Africa, look particularly vulnerable. China’s financial crunch has resulted partly from a sharp reduction in capital inflows from abroad and mounting concerns about bad loans after a multiyear credit binge.

Volatility has reared its ugly head already, leading Brazilian building-materials company Votorantim Cimentos to pull a multibillion-dollar initial public offering, and Russia to cancel two government-bond auctions in recent weeks.

Acquisitions targeting companies in BRIC countries have fallen 16% year on year in 2013, to $155.2 billion, the lowest year to date since 2009, according to data provider Dealogic.

The center can’t hold: “The notion of wanting broad exposure to emerging market assets is likely to be a lot less appropriate than it was a decade ago,” as Goldman Sachs, which coined “BRIC,” puts it.

Countries with large current-account deficits and heavy reliance on commodities, such as Brazil, could prove shaky. But all the Brics countries must grasp the nettle of overhaul before they can be viewed as safer long-term bets. It is unfortunate that they must now do this during a decade that looks much harsher than the last one.


June 23, 2013, 4:13 p.m. ET

A Different Market Picture Is Emerging


Markets are fickle things. It’s only 10 weeks ago that investors responded to Shinzo Abe’s election as prime minister of Japan by pushing up the price of emerging-market assets to record highs. The promise of a vast expansion of Japanese money-printing fueled an already frantic search for yield. Foreign holdings of emerging-market debt had risen to $2.1 trillion and yields fell to the sort of levels historically rarely enjoyed even by advanced economies. Even Rwanda managed to issue a 10-year bond in april with a yield of 6.9%.

The picture now looks rather different following last week’s sell-off. Signs of stronger-than-expected U.S. growth have prompted the Federal Reserve to consider slowing its bond buying, forcing investors to adjust their portfolios to higher interest-rate expectations, emerging markets have been the biggest losers. The MSCI emerging-market index fell 5% last week and is down 15% this year, currencies have fallen and bond yields have risen amid heavy fund redemptions. Now there is anxious talk of the sort of “sudden stop” in emerging-market funding that has previously led to serious economic difficulties.

But the emerging-market sell-off hardly came out of a clear blue sky. Even before the Fed started talking about policy tightening, there were concerns that growth forecasts were too optimistic. The International Monetary Fund expects emerging-market growth of 5.3% in 2013, down from 6.4% in 2011. But strip out China and India, which are forecast to grow by 8% and 5.7%, respectively, and most other developing countries are struggling to grow much above 3%. Meanwhile, the spike in Chinese interbank borrowing rates to an eye-watering 13% has raised fears that the country’s credit boom is about to turn to growth-sapping bust.

A key question now is whether developing countries can take the steps necessary to restore their high growth rates. No less than in the euro zone, this will depend partly on structural reforms. The reality is that the trends that drove two decades of spectacular emerging-market growth since the fall of communism look increasingly played out. As developing countries entered the globalized economy, the combination of abundant cheap labor and access to cheap capital made them a magnet for Western companies looking to offshore manufacturing, which helped fuel rapid industrialization and urbanization.

But rising wages in many emerging markets are eroding this comparative advantage. Meanwhile, the buzzword among Western companies is “re-shoring” as they look to shorten supply lines in response to rising fuel costs, advanced manufacturing techniques and a new awareness of the risks from natural disasters and political instability.

The risk is that many developing countries will hit a “middle-income trap”, says George Magnus, a senior economics adviser at UBS UBSN.VX -1.33% . “There is solid empirical evidence that growth tends to slow down the more mature an economy becomes, and, in particular, once its income per head reaches around $15,000. To break out of the middle-income trap, countries that have exploited more basic models of growth need to adopt “smarter” economic models, designed to boost total factor productivity.”

In fact, total factor productivity gains—gains that exclude improvements in labor and capital productivity—have recently slowed. In China, for example, they halved to 2% in 2012 compared with a roughly 4% average in 2006-10; in India, they have stalled completely. Raising total factor productivity is difficult. It requires policies to boost innovation, reduce bureaucracy, enhance skills and improve infrastructure, and it depends on enforceable property rights and a legal system able to resolve disputes swiftly and fairly.

Take Russia: The country has substantial economic strengths, including abundant natural resources, effectively zero public debt, a well-educated workforce and a stable currency. But with unemployment already low at 5.5% and commodity prices under pressure, it needs to boost productivity if it is to revive slowing economic growth. Yet foreign investors who can provide much-needed money and know-how to improve infrastructure, boost commercial skills and help diversify the economy are wary of investing.

At last week’s St. Petersburg Investment and Economic Forum, an annual gathering of Russia’s political and commercial elites, foreign investors complained of a lack of transparency and respect for law, too much bureaucracy and a culture that seems unable to foster innovation. They are also alarmed that President Vladimir Putin seems intent on boosting the role of state-controlled national champions and purge the government of liberal figures promoted by his predecessor Dmitry Medvedev—a process culminating in the recent voluntary exile of prominent liberal economist Sergei Guriev following a campaign of official harassment.

Indeed, the recent protests in Brazil and Turkey are a warning that the challenge of promoting structural reform could be even harder in emerging markets than in developed markets, where it is no less necessary.

After all, at the core of structural reform is the need to confront vested interests with entrenched privileges that they won’t give up easily.

Much gloomy euro-skeptic commentary has rightly focused on how hard structural reform is to achieve in a democracy, where those vested interests may represent powerful voting blocs. Yet how much harder to confront vested interests in a country where political power isn’t exercised transparently and where trust between groups is low, making it hard to build consensus behind the need for change or provide a peaceful outlet for protest?

Indeed, the real story of the past five years is how Western democracies have by and large delivered structural reforms. The U.S. economy is growing again. A tentative recovery is underway in the U.K. Even the euro zone is forecast to emerge from recession this year.

Substantial overhauls have been undertaken in Spain, Portugal, Ireland and to a lesser extent Italy with remarkably little social unrest despite desperately high unemployment.

Of course, the outlier remains Greece, where the coalition government last week fell apart over the first serious attempt to cut public sector jobs during the crisis. Perhaps it was appropriate, then, that Greece was redesignated this month by index provider MSCI as an emerging market.

June 23, 2013 7:18 pm

Quantitative easing: End of the line

By Robin Wigglesworth and Stefan Wagstyl

With the Fed eyeing an exit from loose monetary policy, emerging markets are coming under pressure

International investors have long shunned Honduras, an impoverished Central American country plagued by violence and coups. That changed this year.

Although Honduras struggles to pay its bills and suffers one of the world’s highest murder rates, it made a bond market debut in March, with investors happy to lend $500m for the next decade. Without the bond, the country could well have defaulted on domestic debts. In large part, Honduras can thank the US Federal Reserve for its unlikely salvation.

The Fed has been at the forefront of central banks seeking to stimulate economic recoveries through creating trillions of dollars to buy bonds and wrestle down global interest rates. Much of the new money has spilled into the developing world as investors have desperately sought better returns in new markets. This helped countries from Honduras to Rwanda gain access to international capital for the first time, and buoyed the bigger developing markets.

But Ben Bernanke, the Fed chairman, has reminded investors and borrowers of an inconvenient truth: the party cannot last forever. On May 22 Mr Bernanke told the US Congress that the Fed’s $85bn-a-month bond purchases could soon be reduced – a message he reiterated last week. His words have echoed across global financial markets but nowhere as loudly as in emerging economies.

The subsequent sell-off in currencies, stocks and bonds has been sharp, deep and indiscriminate. Investor favourites such as Mexico have suffered almost as much as less favoured countries. “We’ve been absolutely spanked,” says one hedge fund manager. Central banks have been forced to intervene to stem currency declines and officials have scrambled to reassure investors but to little avail. The currencies of Turkey and India slid to record lows last week, and emerging stock markets have fallen almost 15 per cent in a month.

Investors have overreacted, argues John Beck of Franklin Templeton, a big US investment group. “The idea that this is a death knell for emerging markets is wrong,” he says.

If not a death knell, it is a warning bell. The era of cheap and abundant central bank money will have to end eventually. When this happens, it will raise many difficult questions for emerging markets, which have been among the main beneficiaries of the Fed’s policy of quantitative easing.

Some investors are concerned that the recent bout of turbulence could be a harbinger of deeper turmoil when QE ends. “Markets will shiver,” says David Jacob, vice-chairman of Henderson Global Investors. “We’ve become addicted to easy money. I don’t see how we can avoid a violent reaction.”

If so, will it prove a temporary spell of turmoil – painful but fleeting – as investors and countries adjust to a new monetary era? Or will it herald a more testing period for emerging markets, with echoes of the crisis-riddled 1980s and 1990s?

A final reckoning is probably not imminent. Even if the Fed cuts the QE programme, it is still not raising interest rates. The Bank of Japan is also aggressively buying bonds. Overall, the central bank-financed party could keep rolling for some time.

In many respects, the developing world is also strong enough to deal with any fallout from a change in the US monetary regime. During previous crises, many countries had pegged exchange rates, low reserves, rigid economies and big US dollar-denominated debt burdens. These vulnerabilities have mostly been addressed.

The latter factor – what economists call the “original sin” of emerging markets – has in the past proved particularly toxic. Historically a strengthening US dollar has spelt trouble for emerging markets due to currency pegs and foreign liabilities. But classic original sin has now been much reduced.

In other words, emerging market balance sheets have been transformed, argues Ramin Toloui, a senior fund manager at Pimco. “Markets can go down and economies may slow but they won’t fall into the death spirals of the 1990s,” he says.

Emerging markets are also far less indebted than developed countries. The overall credit-to-gross domestic product ratio is about 70 per cent against the 145 per cent average for advanced economies, according to the International Monetary Fund.

And although economic growth has disappointed recently, the IMF still estimates that output in developing countries will expand an average of 6 per cent annually between 2013 and 2018. Ample foreign currency reserves will act as insulation against any market chills.

Michael Collins of Prudential Fixed Income argues emerging markets are merely experiencing a “mini-bust” triggered by a reappraisal of Fed policy. He points out that many pension funds and insurers are still keen to diversify away from traditional markets and into emerging ones. “Their horizons are longer and some volatility won’t deter them,” he says.

Norway’s $700bn sovereign wealth fund last year changed its bond index to give emerging markets a bigger weighting. Other big SWFs have followed suit. But many investors have been slower. US pension funds and insurers have an average of 4 per cent of assets allocated to emerging markets but many aim to double that over time.

Each additional percentage point increase in portfolio exposure would funnel $485bn into emerging market bonds alone, according to estimates by BlackRock.

Emerging markets for the most part bounced back quickly and strongly from the global financial crisis, demonstrating their newfound resilience. Optimists say that if they could survive this, the end of QE will prove eminently manageable. Some veterans of past emerging market crises scoff at talk of a rerun.

Hung Tran of the Institute of International Finance argues the longer-term outlook remains positive. “The story remains a compelling story because growth in developed markets will be depressed for some time to come,” he says.

Nonetheless, the withdrawal of central bank money is likely to uncover – and exacerbate – several emerging market vulnerabilities.

. . .

Growth is already slowing, and could slow further if local central banks are forced to raise interest rates to defend their wilting currencies. BNP Paribas recently slashed its emerging market growth forecast to 4.8 per cent this year, down half a percentage point from March.

Slower growth is already having an impact on emerging equity markets, which have recently markedly underperformed bourses in supposedly sickly developed markets. Martial Godet of BNP Paribas highlights a “fast and large” deterioration in earnings growth, profitability and margins since 2012.

The most exposed are countries with current account deficits: those that buy more from foreigners than they sell, and need international capital to bridge the difference. That list is now a long one. The overall current account surplus of emerging markets has shrunk from a peak of almost 5 per cent in 2006 to just 1 per cent this year, according to the IMF. Even that is flattered by the huge trade surpluses enjoyed by the oil-rich Middle East states and China.

Morgan Stanley estimates that the developing world has $1.5tn in external funding requirements to roll over every 12 months. While the bank’s analysts do not foresee this being a problem for the vast majority, some countries are “vulnerable” in a new, less forgiving environment.

Michael Riddell, a fund manager at M&G Investments, says that the recent sell-off was merely a “tremor” and remains convinced that “the big one” is still coming. “Things could get messy,” he warns.

Concerns over some specific countries are already apparent. India, Turkey, South Africa and Brazil all have big current account deficits, and their currencies and markets have been among this year’s worst performers. The dangers are magnified for countries where international investment fuelled domestic credit booms, such as Indonesia. Countries dependent on resource exports are also a source of unease, given the slump in commodity prices.

Many countries also rely on foreign investors to finance budget deficits. Hungary stands out as one country with sizeable foreign liabilities. Even those that rely on local bond markets – avoiding the classic original sin of foreign currency debt – face climbing borrowing costs if international investors pull out.

Deutsche Bank highlights countries including Malaysia, Indonesia, Mexico, Poland, Turkey and South Africa, where foreigners make up a large part of the local investor base.

Any erosion of this would “not only create potential balance-of-payments vulnerability but also pose a risk of disruptive rises in bond yields if foreign investors sell”, Deutsche analysts argue. For the moment the pain is being felt by investors. In the longer run, countries themselves “could also experience macro and funding challenges”.

In some countries political turmoil is exacerbating investor concerns: Recep Tayyip Erdogan, Turkey’s prime minister, has faced public protests; labour unrest has spooked investors in South Africa; and in Brazil, President Dilma Rousseff is facingpublic anger against corruption, poor services and weak infrastructure.

. . .

So is this time truly different? There will inevitably be casualties in a world of less abundant capital. The tide that previously lifted all ships – including those with leaky hulls, such as Honduras – will be less supportive now that the Fed has shifted its position. Some smaller, poorer countries are particularly vulnerable and officials at the IMF and World Bank are worried about possible developmental consequences. Some projects – such as a convention centre in Kigali, Rwanda, which investors financed this year – may prove to be white elephants.

Nevertheless, the developing world has without question seen immense improvements since past crises. Investors will become more careful and discriminating, although they have recently dumped the good along with the bad. Well-run economies such as the Philippines and Mexico are unlikely to suffer too much damage.

Mr Toloui of Pimco concedes that the “golden era of emerging markets growth has definitely passed”. That will necessarily lead to more differentiation by investors. But he argues that the risk of systemic emerging market crises is also greatly reduced.

Others are less optimistic. Stephen Jen of SLJ Macro Partners, a hedge fund, believes investors have piled into emerging markets too uncritically and indiscriminately for the long boom not to end badly. Although he does not foresee a reprise of the crises of the 1990s, he predicts that an inevitable “quake will be a bigger, more intensive version of the tremors we’ve seen so far”.

Additional reporting by Vivianne Rodrigues and Alice Ross


India: Little room to move as economy slows

Jitters about the US Federal Reserve’s quantitative easing could scarcely have come at a worse time for Indiawrites James Crabtree.

Even before Ben Bernanke, the Fed chairman, kicked off a volatile month in the markets with his speech in May, Indian growth had sunk to its lowest level in a decade. The current account deficit has climbed to a record 6.7 per cent, an alarmingly high level even for an economy that has long been dependent on foreign capital inflows.

But just as it appeared a return to growth was possible – in part because moderating inflation and fiscal pressures were expected to allow fresh cuts in interest rates –international turbulence sent the rupee to record lows. This forced the Reserve Bank of India to forgo a rate cut last week. The rupee is likely to translate into more costly oil and raw material imports, fuelling inflation and raising the government’s subsidy bill.

“Of the larger developing economies, India really does stand out as vulnerable,” says Eswar Prasad, an economist at Cornell University, noting flagging growth, weak government and worrying external imbalances.

Raghuram Rajan, the government’s chief economic adviser, argued on a cable television news show that India’s position was weak but other developing nations were doing just as badly.

“The fact is, across the emerging world growth has tanked,” he said.

Yet other experts say a pullback in foreign investment could be especially problematic for an Indian economy where policy makers have little room for remedial measures.

India has been one of the biggest recipients of equity investment in emerging markets, attracting $67bn of inflows since January 2010, more than in the previous decade, according to UBS. That is now under pressure.

Arvind Subramanian of the Peterson Institute says: “India is endangered because its current account is high but there is a deeper concern about its growth story, too.

“Investment is weak, a number of corporates are overextended and the banking system is vulnerable because of that. So where is investment going to come from?”

About bambooinnovator
Kee Koon Boon (“KB”) is the co-founder and director of HERO Investment Management which provides specialized fund management and investment advisory services to the ARCHEA Asia HERO Innovators Fund (www.heroinnovator.com), the only Asian SMID-cap tech-focused fund in the industry. KB is an internationally featured investor rooted in the principles of value investing for over a decade as a fund manager and analyst in the Asian capital markets who started his career at a boutique hedge fund in Singapore where he was with the firm since 2002 and was also part of the core investment committee in significantly outperforming the index in the 10-year-plus-old flagship Asian fund. He was also the portfolio manager for Asia-Pacific equities at Korea’s largest mutual fund company. Prior to setting up the H.E.R.O. Innovators Fund, KB was the Chief Investment Officer & CEO of a Singapore Registered Fund Management Company (RFMC) where he is responsible for listed Asian equity investments. KB had taught accounting at the Singapore Management University (SMU) as a faculty member and also pioneered the 15-week course on Accounting Fraud in Asia as an official module at SMU. KB remains grateful and honored to be invited by Singapore’s financial regulator Monetary Authority of Singapore (MAS) to present to their top management team about implementing a world’s first fact-based forward-looking fraud detection framework to bring about benefits for the capital markets in Singapore and for the public and investment community. KB also served the community in sharing his insights in writing articles about value investing and corporate governance in the media that include Business Times, Straits Times, Jakarta Post, Manual of Ideas, Investopedia, TedXWallStreet. He had also presented in top investment, banking and finance conferences in America, Italy, Sydney, Cape Town, HK, China. He has trained CEOs, entrepreneurs, CFOs, management executives in business strategy & business model innovation in Singapore, HK and China.

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