Another crisis in the emerging markets: time to focus on the economic fundamentals.

2014 has not started well for emerging markets…

The emerging markets have begun 2014 back  in the spotlight as worries over Argentina’s economic health, the continuation of tapering of QE by the Federal Reserve in the USA, and renewed concerns over China’s slowing growth rate have combined to cause turmoil in both financial and currency markets. Stock markets in Asia and Latin America fell to 7 month lows by the end of January and Turkey was forced to increase one of its key interest rates by 425 basis points.

…although the true position is unclear…

However, all is not doom and gloom: the latest EY Rapid Growth Markets Forecast suggests, the long-term outlook remains positive and many commentators believe that conditions  in 2014 are significantly more favourable than   in 1997 when the Asian financial crisis sent shock waves through the world economy. This positive sentiment reflects  changes such the widespread move to flexible exchange rates and  the build up of sizeable foreign exchange reserves by many countries compared to 1997.

Since 2005, $7 trillion of funds have been invested in emerging market assets and funds, peaking at around 9% of emerging market GDP in recent years. The scale of the investment in emerging markets in recent years goes a long way to explaining why not everyone is convinced about the resilience of the emerging markets and there is clearly a degree of investor nervousness that has been led to shifts in markets.  So, while conditions may be different to 1997, the degree of exposure is now much greater and hence any shock waves could reverberate far and wide. The Bank for International Settlements is more concerned than most observers and argues that the rapid growth of bond issuance at low interest rates, companies and banks in emerging markets raised $2 Trillion in bonds from 2010 to mid-2013 alone, is today a major risk factor  that was largely absent in 1997.

… and so  businesses must focus on the fundamentals…

Money flowed into the emerging markets in the last decade or so in pursuit of economic growth rates and long-term demographic upsides that were not available in the developed markets. As interest rate differentials to developed markets increased further after the financial crisis so the funds flow continued even in a slowing world economy.

As  developed world economies begin to recover, especially the USA, so the emerging markets are being viewed in a different light. Growth is slowing in many emerging markets as the commodity cycle comes to an end and policy makers are being forced to raise interest rates to address concerns over either currency levels or domestic inflation.

It is becoming increasingly clear to investors that many countries did not take the opportunities offered by cheap money and access to plentiful capital to invest in productivity enhancing investment to support long-term economic growth. Rather, in many cases, resources were squandered, often deployed either to buy off interest groups or to mask economic weaknesses. Many countries have come to regard foreign financial inflows as business as usual.

…at the country level…

The most striking trend in the market and currency movements first seen in mid-2013 and again recently is the way in which investors are now differentiating between countries: emerging markets are no longer one asset class. Investors are looking much harder at economic fundamentals.

Eichengreen and Gupta found that the most vulnerable countries are likely to be those with the weakest foreign currency positions and with the largest domestic financial markets, the higher liquidity making it easier for investors to exit. Beyond these immediate pressures however, the economies under pressure beyond the immediate crisis will be the ones that have failed to drive domestic macroeconomic reform.

Businesses now need to update their geographic and sector portfolio plans to incorporate the latest economic outlook. Not only has the balance between developed and developing market growth rates changed but so has the relative riskiness. In 2013, it is likely that the average rate of growth in Brazil, Russia and South Africa was no faster than growth in the UK and USA and the latter two countries appear to have much more stable outlooks.

In assessing the long-term economic potential and risk of a country, the key factors to analyse include:

  • degree of dependence on foreign funding especially portfolio flows as opposed to foreign direct investment;
  • exposure to foreign currency denominated debt;
  • strength of the domestic banking sector;
  • relatively high reliance on commodity exports;
  • relatively high domestic inflation;
  • high levels of debt either sovereign or private sector or consumer;
  • degree to which foreign exchange reserves cover imports.

When several of these factors are present then the risk is that a country is more exposed to shocks and economic performance could be hampered for a significant period of time.

… including the political and policy risks.

The long-term growth story for emerging markets remains positive especially for those with favourable demographics, but this growth may take more time to materialise than previously thought, and companies will then find that it takes significantly longer to realise value from their investments in emerging markets.

Companies will have a good idea of how they can drive change in the businesses they invest in, but the need is to understand in parallel how the macroeconomic and policy environment will influence performance over the medium to long-term. Productivity must be improved and this is likely to require microeconomic reforms across sectors, a redesign of the role of the state in many economies and greater macroeconomic discipline.

This requires an assessment of the potential for the political system to support the introduction of policies to drive economic transformation and address the risk factors identified above. In 2014 the outlook will be even more uncertain as many significant emerging markets are due to hold elections. The outlook for Brazil, India, Indonesia, South Africa and Turkey as well as others is therefore even harder to call.

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