Investors are fleeing once-popular emerging markets

31 Aug 2015 | Author: | No comments yet »

Brazilian real falls to another record low vs. the dollar.

There is a consistent thread of discussion regarding the impending Fed rate hike and its impact on various markets, which are known to front-load the expected returns impact of the entire series of hikes in the first hike.While emerging markets stand to be worst affected by China’s slowing economic growth and stock market volatility, they rallied strongly after the world’s second largest economy cut interest rates and on hints that the US Federal Reserve may delay an interest rate hike, which had been expected next month. The real, one of the worst-performing emerging-markets currencies of 2015, traded at 3.67 to the dollar, down 2.3% from its level late Friday in New York.

As I was finishing off my course at the Yale School of Managment on “The Future of Global Finance” this past May, a student came up to me. “You have gone to great lengths to emphasize the role of emerging markets in a changing monetary system, “ he said, “ but everything I have been reading says that the era of the Brazils, the Indias, the Turkeys, the Indonesias as up-and-comers is history. Have you been looking backwards and not forward?” Standing at the podium and gathering my lecture notes, all I could muster in the moment was something about how important it was to separate the signal from the noise. Policy makers are also likely to defer planned rises in interest rates.’ Michael Hasenstab, who runs a range of bond funds for Franklin Templeton, argued that the downturn in global markets that culminated in Black Monday’s crash had presented ‘once in a decade’ opportunities in beaten-up emerging market currencies. ‘The new opportunity that has come about over, really, the past month is one of those once a decade opportunities where you’ve seen in places like the Mexican peso, the Malaysian ringgit, the Korean won, the Indonesian rupiah, the Brazilian real, a number of key emerging markets currencies have tested at all-time lows,’ he said. ‘In Asia, many of the currencies are approaching or are at the levels that we didn’t see since the Asian financial crisis, when Asia was the source of the crisis. What a higher U.S. interest rates does is increase returns expectations of “safe” investments, making them more attractive relative to risky alternatives, and thus change the expectation of acceptable returns. Today fundamentals are very different than they were back in the late ’90s that caused that crisis,’ he added. ‘In fact, most countries have significantly higher reserves from large current account surpluses, growth is on much stronger footing than it was back in that period where there was an investment bubble, and huge macro imbalances that led to a collapse.

Political issues stemming from a corruption scandal at the state-controlled energy firm Petrobras have also shaken confidence in the country’s government. The last few weeks of escalating crisis for emerging-market countries started to make me feel that maybe the student was more correct than I had acknowledged. We’re seeing tremendous value in that region.’ Citywire AAA-rated Andrew Swan, manager of the BlackRock Asia and Asia Special Situations funds, pointed to strong growth prospects for Asia despite the market volatility. ‘Despite some near-term growth stumbles, Asia’s prospective growth rates are still three times that of developed economies: 6% versus 2%, according to Goldman Sachs estimates,’ he said. ‘When Asia has traded in the valuation range of 0.9 to 1.4 times book value (current level is 1.3 times book value, Citigroup data shows), then the probability of a positive return on a 12-month and 36-month view is greater than 80%.’ In 1995, for example, President Bill Clinton’s administration coined a term, “big emerging markets,” consisting of 10 countries that had large populations, large markets, and substantial influence in their regional neighborhoods.

In 1996, a Yale research team headed by historian Paul Kennedy published articles (and later a book) proposing that Washington give foreign-policy and economic priority in the developing world to nine “pivotal states” whose fates would be central to the problems of the 21st century: Indonesia, India, Turkey, South Africa, Brazil, Mexico, Egypt, Pakistan, and Algeria. (China was excluded because, for the Yale group’s purposes, it was considered a great power alongside Russia.) Then, in 2001, Goldman Sachs, led by Jim O’Neill, then its senior research executive, published an analysis identifying four countries that would become global economic powers alongside the United States and Japan. They were labeled the BRICs: Brazil, Russia, India, and China. (Eventually South Africa was added.) Since the 1990s, however, much larger groupings encompassing countries such as Malaysia, Colombia, and Israel have been established by the United Nations, the IMF, the World Bank, Morgan Stanley, and other organizations, each list being used for different purposes, such as investment, social progress, etc.

In July 2013, the Economist wrote, “The most dramatic, and disruptive, period of emerging-market growth the world has ever seen is coming to its close.” This past April, the Wall Street Journal paraphrased the IMF as stating, “Emerging markets are on course for the sixth consecutive year of falling growth rates, led by a faster-than-expected slowdown in China, a steep contraction in Russia and recession in Brazil.” In July, the IMF showed emerging markets’ collective growth decelerating from 5.0 percent in 2013 to 4.6 percent in 2014 to 4.2 percent this year. Emerging-market stock markets have been flat for the last six years and have given up all the comparative gains they made over stocks from developed countries.

One interesting use the index provides is that it grants investors the ability to more accurately track emerging markets – many of whom are dependent on commodities. It is no wonder that outflows of funds from emerging markets have accelerated and exceeded $1 trillion in the last year. “The worry is that these problems are no longer contained within emerging market economies,” wrote Jonathan Wheatley and James Kynge of the Financial Times presciently as far back as June, “The dependable boost that the global economy has derived from the youthful dynamism of its developing countries for well over a decade … has recently become an outright drag.” They were correct, of course, as we are now seeing. China, for instance, is a net commodity importer and thus is separated to a degree in the analysis: The obvious way to de-trend currencies is to put them in real terms, using inflation differentials. The results of such a process are shown in Figure 1, with two versions of our real trade weighted EM currency index – one with the Chinese yuan, the other without. In China, stock market and currency turbulence have raised serious questions about whether the Middle Kingdom is in for much harder times, whether the heyday of rapid growth is over, whether its fundamental economic and political model is seriously flawed, and, indeed, whether its top officials are up to the challenge.

The recent divergence is unusual and reflects both the recent strength of CNY and the fact that China now accounts for 37% of the trade weighted basket (in 1990 it was only 12%). In Brazil, a broad corruption scandal and accusations that the government has illegally manipulated its fiscal accounts have not only helped stall the economy — actually it just entered into a recession — but threaten to create political turmoil of a kind not seen since the transition to democracy from military rule in the 1980s.

Versus both emerging market and developed market currencies, those playing close attention to emerging markets should place more weight on the influence of commodities than the Fed. In Turkey, political stalemate created by a dictatorial president, a massive refugee problem, and escalating military involvement with Syria have cast a serious pall over necessary reforms. While the two may be linked, the report notes, seperating analysis of both can lead to a clearer picture of core performance drivers of strength and weakness. For starters, there was excessive exuberance in the 1990s concerning the idea that a post-Cold War new world order would emerge quickly and that China, India, and Brazil were in the vanguard.

The mid-to-late 1990s was also a high-water mark of globalization, with global trade and investment flows across borders growing at extremely fast rates. In retrospect, many projections just assumed that the highly positive global economic conditions would continue and that relatively easy policy reforms in emerging markets such as tariff reductions would be followed by much more difficult ones, such as liberalization of restrictive labor practices. Exceedingly low interest rates in the world’s advanced countries and the cheap capital those rates spawned allowed emerging-market governments and their private sectors to go on a borrowing spree. In fact, the long, hard road to political reform and the obstacles to establishing effective, transparent government administration were seriously underestimated.

Let’s stipulate, then, that it was never in the cards that emerging markets would become all that was hoped for in the time frame that so many politicians, economists, and other observers assumed. When the Cold War and the two-superpower framework for geopolitics ended, we were witnessing what Fareed Zakaria labeled “the rise of the rest.” It would no longer be a world dominated by the West. Chalk this up to learning from mistakes, such as moving to flexible exchange-rate systems that are far less susceptible to speculative attack, or more prudent debt-management policies that reduced the extent of bankruptcies in the private sector. Iran was never classified as a big emerging market, but with the imminent lifting of sanctions, it certainly will be and will constitute another global hot spot.

The world’s foreign exchange reserves held by emerging markets relative to reserves held by developed markets grew from approximately one-half in 2000 to roughly 2 times in 2015. For example, Brazil may be in a serious recession now, but its external debt as a percentage of GDP is less than 50 percent of what it was in 2002, and its reserves as a percentage of its debt are more than four times what they were in 2002. Conference on Trade and Development’s 2015 World Investment Report, FDI in developing countries increased tenfold between 2005 and 2014, about 30 percent faster than it did in the advanced industrial nations. The governance of the global financial system is no longer in the hands of the G-7 industrialized nations but under the auspices of the G-20, in which emerging markets are in the majority. Failure to do so has already led to the establishment of the Beijing-based Asian Infrastructure Investment Bank, a potential forerunner to other organizations that could challenge those that have been at the center of American global influence.

China, India, Brazil, Indonesia, and others will play a critical role in the outcome of December’s all-important global conference on climate change in Paris, and in every other global issue, from migration to human rights to intellectual property rights. I plan to introduce the subject with a story from one of my other courses a few years ago called “China in Global Markets.” For years I brought 20 students to meet with top economic and financial leaders in Shanghai, Beijing, and Hong Kong. That’s what keeps me up at night.” These questions of what happens after a crisis, what can be learned from it, and what can be done to put policies on a more effective plane are, of course, critical ones for China right now.

Will they accelerate reforms that provide more resilience, such as stronger social safety nets, more flexible labor policies, expanded educational opportunities?

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