The fu­ture of Emerg­ing Mar­kets

Financial Mirror (Cyprus) - - FRONT PAGE -

Over the past year, the global eco­nomic en­vi­ron­ment changed markedly and in un­ex­pected ways. Energy and com­mod­ity prices plunged. Growth in China (which ac­counts for about 40% of global growth) fell to its low­est rate since 1996, even as its stock mar­ket soared to un­sus­tain­able heights. The United States and the Euro­pean Union ratch­eted up eco­nomic sanc­tions on Rus­sia in re­sponse to its mil­i­tary ex­cur­sions in Ukraine, high­light­ing the geopo­lit­i­cal risks as­so­ci­ated with cross-bor­der in­vest­ments. And there have been large swings in ex­change rates, fu­eled by ac­tual or, in the case of the Fed­eral Re­serve, an­tic­i­pated changes in mon­e­tary pol­icy.

These rapid changes have rat­tled global fi­nan­cial mar­kets and spooked in­vestors, re­duc­ing their ap­petite for risk – a cau­tious at­ti­tude that has been re­flected in emerg­ing mar­kets. In­vestors have sat on the side­lines, and the MSCI in­dex that tracks re­turns on emerg­ing-mar­ket eq­ui­ties has stag­nated.

Dur­ing the sec­ond half of last year, the 15 largest emerg­ing-mar­ket economies ex­pe­ri­enced the big­gest cap­i­tal out­flows since the 2008 global fi­nan­cial cri­sis. And the ag­gre­gate for­eign-ex­change re­serves held by emerg­ing coun­tries de­clined for the first time since 1994, when they be­gan the steep up­ward climb that has been a defin­ing fea­ture of the global econ­omy dur­ing the last two decades.

One ma­jor fac­tor driv­ing the lack­lus­ter per­for­mance of in­vest­ments in emerg­ing mar­kets is the ex­pec­ta­tion that the Fed will be­gin to raise in­ter­est rates and nor­malise mon­e­tary pol­icy later this year. In a re­cent speech, Fed Chair Janet Yellen con­firmed that such steps would be “ap­pro­pri­ate” if the econ­omy con­tin­ues to im­prove, stat­ing that “de­lay­ing ac­tion to tighten mon­e­tary pol­icy un­til em­ploy­ment and in­fla­tion are al­ready back to our ob­jec­tives would risk over­heat­ing the econ­omy.”

Ex­pec­ta­tions of a rate hike have re­stricted flows to emerg­ing mar­kets ever since 2013, when the Fed trig­gered what came to be called the “ta­per tantrum” by an­nounc­ing that it was likely to re­duce its bond-buy­ing pro­gramme. The re­sult­ing alarm roiled US fi­nan­cial mar­kets and spilled over in­ter­na­tion­ally. Emerg­ing-mar­ket economies came un­der in­tense pres­sure, with in­flows to in­vest­ment funds fall­ing sharply, as­set prices de­clin­ing, and many cur­ren­cies los­ing value against the dol­lar.

For­tu­nately, the worst of the ta­per tantrum proved tem­po­rary. Cap­i­tal in­flows re­cov­ered some­what, and most emerg­ing-mar­ket economies weath­ered the fi­nan­cial dis­tress in their cap­i­tal mar­kets. But the ex­pe­ri­ence raised ques­tions about the ef­fects of fu­ture moves by the Fed. Stan­ley Fis­cher, the Fed’s vice chair­man, said re­cently that he ex­pects the an­tic­i­pated in­crease in the Fed’s pol­icy in­ter­est rate later this year to “prove man­age­able” for emerg­ing-mar­ket economies. But sud­den steep declines in for­eign cap­i­tal in­flows trig­gered by the Fed’s ac­tion could ex­ac­er­bate the chal­lenges that even the best-per­form­ing Asian economies are fac­ing, as ane­mic de­mand in their ex­port mar­kets causes growth to slow.

The Fed has tried hard to be very clear about its pol­icy in­ten­tions, strate­gies, and tim­ing to en­sure that in­vestors are not sur­prised. In re­cent years, as­sets in emerg­ing-mar­ket economies – es­pe­cially cur­ren­cies – have de­pre­ci­ated by 550% rel­a­tive to the dol­lar, re­flect­ing both ex­ter­nal im­bal­ances and the broader macro con­di­tions of in­di­vid­ual coun­tries. There is a wide­spread view that most emerg­ing fi­nan­cial mar­kets have al­ready priced in the ef­fects of a grad­ual in­crease in in­ter­est rates. But that does not mean that these ef­fects will be in­signif­i­cant for coun­tries that in­vestors al­ready re­gard as risky.

As in­vestors have be­come more cau­tious, they have also be­come more dis­crim­i­nat­ing. The dif­fer­ence in re­turns across emerg­ing coun­tries and among sec­tors within them has grown. The coun­tries at great­est risk of large cap­i­tal out­flows in­clude those that are de­pen­dent on ex­ter­nal fi­nanc­ing, those with com­mod­ity-heavy economies, and those with un­cer­tain po­lit­i­cal con­di­tions.

Many of the best per­form­ers are in Asia – the only re­gion where sev­eral economies have grown by 5% or more for at least four decades. Over the last year, the MSCI in­dex for Asia in­creased by 10%, even as it fell by roughly 14% for emerg­ing and fron­tier mar­kets and by 21% for emerg­ing mar­kets in Latin Amer­ica. And, in­deed, Asia’s two largest emerg­ing economies of­fer rea­sons for cau­tious op­ti­mism.

China is cer­tainly not free from risk. The re­cent eq­ui­ty­mar­ket rally is largely di­vorced from fun­da­men­tals and is driven by spec­u­la­tive, debt-fi­nanced pur­chases. The out­look for cor­po­rate prof­its re­mains weak; the coun­try’s eq­uity sup­ply is grow­ing; and val­u­a­tions are stretched. Up to 10% of China’s eq­uity mar­ket cap is funded by credit – five times the av­er­age in de­vel­oped economies.

But China also has sub­stan­tial wrig­gle room in its mon­e­tary and fis­cal pol­icy to con­tain the ad­verse con­se­quences of its debt buildup, real-es­tate boom, and ir­ra­tionally ex­u­ber­ant stock mar­ket, while si­mul­ta­ne­ously pur­su­ing bold struc­tural re­forms in its econ­omy and cap­i­tal mar­kets. China’s growth rate may have dropped from a three-decade av­er­age of 10% to a 25-year low of 7%, but that slow­down has been largely the re­sult of poli­cies to re­duce fixed in­vest­ment and move the econ­omy from man­u­fac­tur­ing to ser­vices. Em­ploy­ment re­mains strong, and the mid­dle class is grow­ing rapidly.

Mean­while, in In­dia, the i mple­men­ta­tion of Prime Min­is­ter Naren­dra Modi’s am­bi­tious re­form agenda has been slower than an­tic­i­pated. But in­fla­tion is down; the fis­cal sit­u­a­tion has im­proved; and the econ­omy has ben­e­fit­ted from the drop in oil and com­mod­ity prices. Growth of 6-7% seems achiev­able, and Modi re­mains a pop­u­lar re­for­m­minded leader whose poli­cies are at­tract­ing the sup­port of do­mes­tic in­vestors.

As global in­vestors nav­i­gate the un­cer­tain wa­ters of emerg­ing mar­kets in the next few years, they should re­mem­ber that, for these economies, the wave of in­dus­tri­al­is­tion and ur­ban­i­sa­tion and the as­so­ci­ated pro­duc­tiv­ity gains are far from over. With their faster­grow­ing pop­u­la­tions and pro­duc­tiv­ity, they will en­joy a growth ad­van­tage over de­vel­oped economies for some time to come.

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