Emerging markets face tough year with no saviour; The Emerging-Market Comedown; Emerging Markets Get Ready for a Bumpy Ride

Updated: Wednesday January 22, 2014 MYT 12:21:13 PM

Emerging markets face tough year with no saviour

BY JAMES SAFT

Unlike previous recent crises, first in the US and then Europe, it is unclear what institution has both the will and the means to stand as a backstop if emerging markets as a group experience a crisis.The IMF is arguably under-gunned, the Federal Reserve and European Central Bankare both responding to complex and diverging domestic developments and central banks within emerging markets are likely to be both too small and pulling in different directions.

After a tough year in market terms in 2013, emerging markets face a number of critical challenges in 2014.

First, from a very long-term point of view, it appears that a long boom in commodity prices, a classic driver of growth in emerging markets, has played itself out. This will pressure budgets and crimp growth.

More immediately, emerging markets countries, many of which have to attract capital to make up for current account deficits, are ill-prepared after enjoying easy conditions not of their own making for years.

Very easy money from the Federal Reserve, augmented by other central banks, made life in the global capital markets a borrowers paradise, but many countries did little by way of fundamental reform to prepare for tighter times later.

That is now ending, or has ended.

As the Fed backs away from buying bonds, tapering its purchases in coming months, monetary conditions globally will baecome tighter, with those who need money most the most affected. Emerging markets, including India, South Africa and others, are the ones that need money most.

This will only be exacerbated by a widening gap between growth in emerging and developed markets.

“Emerging markets knew well that the capital inflows they were receiving from 2009-2012 were one day going to leave, and had few macro tools to either absorb or block out these flows,” hedge fund manager Stephen Jen, of SLJ Macro Partners wrote in a note to clients.

“This was why we have long described the impending EM crisis as the necessary third phase of the global financial crisis.”

In Jen’s view, what we have had since 2008 is essentially a rolling global crisis.

First came the sub-prime mortgage episode in the US, punctuated by the failure ofLehman Brothers, and only arrested at great cost and with uncertain long-term results by the combined efforts of the Fed and the US Treasury.

Next came the euro crisis which itself was far harder to counter because of institutional arrangements in Europe. Only after much difficulty did the ECB step in in 2012 to provide an effective backstop for weakened peripheral states, such as Ireland, which otherwise might have faced a financing death spiral.

NO BOLD MOVES

Of course, there is no Fed or ECB of emerging markets, or at least not one with the size and remit. The IMF probably has not got the firepower, and while its thinking has evolved from the days in which it expected troubled borrowers to starve themselves to

health, it is highly unlikely to make a move as bold as that of the ECB in August of 2012, when Mario Draghi pledged to do “whatever it takes”.

The Bank of China will look after China, a relief for the rest of the world, but it’s something that may only leave those emerging markets without the means to weather their own storms more exposed.

Even if Russia becomes involved, as well it may, the sheer weight of the economies which face difficulties may not be enough to make the Federal Reserve think twice about pursuing its own domestic aims.

Just as the Fed did not intend to create conditions in recent years which were far too loose for emerging markets, nor will it in 2014 intend to make things for developing nations far too tight. Emerging markets will simply be collateral damage.

If the Fed does carry on with its apparent plan to rapidly cut back on bond buying, the best we can hope for is a year which is ugly for emerging markets from an investors’, or inhabitants’, point of view, rather than one which features a genuine funding crisis.

If so, the third phase of the global financial crisis may prove the hardest to arrest but the least damaging to the global economy.

At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com and find more columns at http://blogs.reuters.com/james-saft.

Ruchir Sharma: The Emerging-Market Comedown

Most developing economies grow rapidly only when commodity prices are rising.

RUCHIR SHARMA

Jan. 21, 2014 7:37 p.m. ET

The beguiling idea of “convergence” still lives. But it shouldn’t. The basic notion of convergence is that incomes in poor nations will rapidly catch up—or converge—with those in rich nations. This argument gained a popular following over the past decade when emerging economies were growing three times faster than the world’s leading economy, the U.S. After the average annual GDP growth rate in emerging nations peaked at 8.7% in 2007, it tumbled to roughly 4% in 2013. Yet to many observers, that pace still appears fast enough for these countries to catch up to the U.S., now growing at an annual pace of just over 2%.

Look closer, however, and the picture changes dramatically. Once you exclude China, GDP growth over the past two years has been no higher in emerging nations than in the U.S. Convergence has halted across a broad front, and after losing ground for much of the last decade, the U.S. share of global GDP has stabilized since 2011 at 23%, while the share held by emerging markets excluding China has stabilized at 19%.

Some of the biggest emerging market stars of the last decade, including Brazil, Russia and South Africa, are now growing at a pace slower than that of the U.S. This trend is unlikely to change in the foreseeable future. These countries are in fact “deconverging.” Even China’s reported 2013 growth rate of 7.7% looks increasingly unsustainable given the amount of debt it is taking on to hit this ambitious target.

None of this should be surprising because economic history shows convergence is largely a myth. The tailwinds that stir periods of rapid convergence—including easy money and booming commodity prices during the past decade—never last. Emerging economies rarely grow fast and long enough to rise into the developed world. There were at least as many nations losing ground as catching up in every decade but one since 1960. The exception was the past decade. Between 2005 and 2010, only three countries did not increase their GDP per capita relative to the U.S.: Niger, Eritria and Jamaica.

The tailwinds that produced this rare mass convergence are now gone, and the emerging world is returning to its normal state, with just a few nations on a rapid convergence path. The current stars include countries such as the Philippines, Colombia and Peru. But these catch-up stories are unlikely to last indefinitely, because hot growth streaks rarely run for more than a decade. Rapid expansions have often ended in a crisis or contraction, wiping out much of the gains made during the boom.

Catch-up is hard to sustain, and one popular answer for this difficulty is the middle-income trap. This theory holds that a poor nation can grow at catch-up speed through simple improvements such as paved roads but will find it difficult to continue at catch-up speed when it hits the middle-income level and needs to develop advanced industries. Today, there is much speculation that emerging markets—including Brazil, South Africa and Russia—are losing catch-up momentum simply because they are in or approaching the middle-income level.

New research, however, shows that “development traps” can knock countries off the catch-up path at any income level. The challenges of developing industry—backed by better banks, schools and regulators—do not accumulate and confront an economy all at once. They continue to harass an aspiring nation every step up the development ladder. In a September 2013 paper, World Bank researchers found many examples of economies that have suffered setbacks at the threshold of every per-capita GDP level, from lower to middle to upper incomes. Their analysis of these transitions found “little support for the idea of a middle-income trap.”

In some cases, development traps can drag newly rich countries back to the middle-income ranks, as has happened to Argentina and Venezuela in the past century. Since the late 1950s, many nations have also slid back from the middle- to the lower-income class, including the Philippines in the 1950s, and Russia, South Africa and Iran in the 1980s and 1990s. Every decade tosses up new convergence stars—from Iraq in the 1950s to Iran in the 1960s and Malta in the 1970s—that flame out in the next decade.

Nonetheless, boom periods are often misread as a sign that developing nations are successfully working their way up the development ladder. Many emerging markets rely heavily on commodities for the bulk of their exports, and they grow at catch-up speeds—at a rate faster than the world’s leading economy—only when commodity prices are rising.

Commodity prices rose 160% in the 1970s, and the number of nations that were rapidly catching up to the West rose to 28, compared with the average of 22 in the typical decade. In the 1980s and 1990s, when commodity prices stagnated, the number of rapidly converging nations fell to just 11. Commodity prices then doubled in the 2000s, another golden age for convergence, with 37 nations catching up at a rapid pace.

But commodity-driven economies such as Russia and Brazil tend to stop catching up as soon as commodity prices spiral downward. According to the World Bank, of the 101 middle-income economies in 1960, only 13 had become and still remained high-income by 2008: Equatorial Guinea, Greece, Hong Kong, Singapore, Ireland, Israel, Japan, Mauritius, Portugal, Spain, Puerto Rico, South Korea and Taiwan. Of those 13, only Equatorial Guinea is a commodity-dominated economy.

Last decade’s mass convergence was a freak event that caught the world’s imagination. However, it never pays to extrapolate from the recent past into the distant future. That is particularly true in the emerging world, where economic growth is characterized by sharp but short booms, often fueled by unstable commodity prices. Don’t assume all emerging markets are destined to grow faster than the U.S.—or that some mythical force called “convergence” will carry every emerging nation on a straight path to prosperity.

Mr. Sharma is head of emerging markets at Morgan Stanley Investment Management and author of “Breakout Nations: In Pursuit of the Next Economic Miracles” ( Norton, 2012).

Emerging Markets Get Ready for a Bumpy Ride

Emerging markets are attractive, but only if you look beyond the short term

CHARLES FORELLE

Updated Jan. 21, 2014 10:17 p.m. ET

In 2013, the world’s emerging markets had a case of the tapering blues. This year, the diagnosis is more complex.

The pendulum of global growth is swinging away from emerging markets to the U.S., and even to much-maligned Europe. The once-strong inflows of capital are slowing down. And years of superheated expansion have left some emerging markets with troubled economic fundamentals—on a broad measure those countries now import more than they export.

In short, after years of distortion from crisis and crisis response, the world is rebalancing. For emerging markets, the path will surely be bumpy.

Steen Jakobsen, chief economist at Saxo Bank, says the emerging economies of Asia especially need to make a priority of more-durable but lower-return investments, such as in infrastructure—and accept lower growth. Northern Europe needs to consume more. Southern Europe needs to consume less.

“Everybody is moving to a new point,” he says.

Investors are well aware of the turmoil. Emerging markets are coming off a year of terrible performance that stands out against a backdrop of rising asset prices and rising risk appetite almost everywhere else.

The broad MSCI emerging-market stock index, priced in dollars, is down 10% in the last 12 months; the Bank of America BAC 0.00% Merrill Lynch emerging-market government-bond index is off 17%.

The Dow is up 20% and the Stoxx Europe 600 is up 17% . Japan’s Nikkei is up 47%—and even adjusting for the declining yen it is up 26%. Risky assets like high-yield corporate bonds in Europe have held up, even as risky emerging markets slumped.

Some of the jarring came from the U.S. Federal Reserve’s move to reduce the pace of its monetary stimulus. Investors who had put the excess cash to work in emerging markets—because the Fed’s buying of Treasuries had pushed down yields—reversed gear. Investors pulled $89 billion from emerging-market stock and bond funds between June 2013 and the end of the year, according to EPFR Global, a data provider whose figures cover many but not all investments. (The Fed broached tapering at the end of May.) In the prior two years, investors had poured in $155 billion. Long-dated government bond yields have shot up in emerging markets, exceeding the rise in yields in U.S. Treasurys that has come from tapering. Bond prices fall when yields rise.

But the issues are broader than just the Fed.

Investors are especially sour on countries with large current-account deficits, among them the Fragile Five of Brazil, India, Indonesia, South Africa and Turkey. They’re reliant on foreign money to plug that gap. Political uncertainty is another drag. Countries with both political problems and economic ones—take Turkey, wrestling with a current-account deficit and a corruption scandal—have the worst of both worlds.

For foreigners, declining currencies make investment decisions difficult, even if recent underperformance has made emerging-market stocks look favorably valued against their American and European peers. Turkey’s benighted lira has fallen 22% against the dollar in the past year.

“The problem is you are going to lose more on the currency than you are going to gain on the investment,” says Mr. Jakobsen.

Salman Ahmed, global fixed-income strategist at Lombard Odier Asset Management in London, says investors need a nuanced approach. In the short term, “you will not have an asset-class-wide move,” he says. “It will be very country specific.” Mr. Ahmed says countries like Mexico, where the economy is more balanced, are potential bright spots; Turkey, for instance, isn’t.

In the longer term, though, emerging markets are attractive. “Nowhere in emerging markets will you find the debt-to-GDP ratios you have in Europe.” And, he adds, many of them have reformed their economic policies. “These countries are nowhere near the problem states they were in 2003 or in the late 1990s.”

January 21, 2014 8:37 am

Too early to take plunge back into EMs

By John Plender

Emerging market woes could deepen before things improve

Appetite for global equities at the start of 2014 has been keen, but emerging markets remain stubbornly submerged.

According to data provider EPFR Global, emerging market equity funds saw 12 consecutive weeks of net redemptions in the period to mid-January. Both retail and institutional investors have been responsible for the exodus, which clearly demonstrates how the Federal Reserve’s retreat from quantitative easing continues to weigh on the developing world. The question is whether markets are overreacting.

This is not, after all, a rerun of the Asian crisis of 1997-98. Banks are not falling like dominoes, the International Monetary Fund is not in manic rescue mode and nobody is donating their gold jewellery to the nation, as the South Koreans did back then.

Much of the story that convinced developed world investors that emerging markets were no longer a volatile bet on extreme economic cycles remains intact. In the long run emerging markets can be relied on to outgrow the economies of the developed world. National finances have been underpinned by a vast accumulation of foreign exchange reserves since the Asian crisis. There is much less dependence on foreign debt.

Exchange rates

Why, then, have emerging markets been so badly hit since last May when Fed chairman Ben Bernanke started to talk about tapering? Clearly markets were taken by surprise. But underlying the change in perceptions over the rest of 2013 was a recognition that the differential between the growth rates of the developed and developing world was narrowing as the US economy picked up and the European Central Bank succeeded in damping down the sovereign debt crisis. At the same time growth rates in countries such as China were slowing, bringing down commodity prices, which were, in turn, important to other emerging markets.

Investors became more discriminating: worst hit were countries that had allowed their current account deficits to widen in the period when finance was readily available and found themselves overdependent on short-term bank and portfolio finance. The most toxic were those such as Turkey where dependence on hot money was compounded by bad politics. The decline in Turkish equities was close to 30 per cent over 2013 and the currency remains under pressure.

Yet there is one respect in which the outflows were not discriminating. An interesting analysis of changes in exchange rates, foreign reserves and equity prices between April 2013 and August 2013 by Barry Eichengreen and Poonam Gupta found little evidence that countries with stronger macroeconomic fundamentals such as smaller budget deficits, lower debts, more reserves and stronger growth rates were rewarded with smaller falls in exchange rates, foreign reserves and stock prices from May.

The biggest impact of tapering was felt by countries that allowed exchange rates to run up most dramatically in the period before May when expectations of continuing Fed easing allowed large amounts of capital to flow in. So, ironically, those who were most vociferous about currency wars when quantitative easing began were equally chastened when QE’s end came into view.

Back to EM stocks?

A more fundamental and potentially disturbing finding in Eichengreen and Poonam’s paper is that an important determinant of the differential impact of taper talk was the size of a country’s financial market. Countries with larger markets experienced more pressure on the exchange rate, reserves and the stock market. In other words investors were seeking to rebalance their portfolios by emerging from those emerging markets that offered the greatest liquidity. This is not an encouraging message for countries such as China that see capital market development as part and parcel of rebalancing the economy away from investment and exports towards consumption.

Equally striking, neither capital controls nor fiscal tightening, nor even a combination of the two, was enough to damp financial inflows. Macroprudential policies such as limits on bank lending growth and loan to value regulation for the mortgage market appear to have been more effective in moderating upward pressure on the currency and the widening of the current account deficit.

So when will it make sense to take a contrarian view on emerging market equities? The snag is that the valuation discount relative to developed world equities is not that great by historic standards. And where the discounts do look tempting the problems are big. Talking to officials and business people in Istanbul last week, I was left feeling that a combination of the erratic recent behaviour of prime minister Recep Tayyip Erdogan, who nurses a visceral dislike of rising interest rates, and heavy dependence on hot money flows, is a formula for things to get worse before they get better. It is too early to take the plunge.