Time to Reassess the Emerging Markets Landscape?

The last decade may well be remembered as the golden era for Emerging Markets (EM). These economies emerged from the crisis of the 90s and experienced a success story of restructuring and strong growth early in the millennium. Cheap labor markets and massive capital inflows, along with extraordinarily loose monetary policies put in place globally to fight recession, were behind the EM renaissance.

The announcement in late 2013 of a “tapering” of monetary stimulus in the U.S. provided an abrupt wake-up call for investors. The prospective end of the abundant flows of central bank liquidity into financial markets, which helped fuel EM investing after the 2008 crisis, focused investors on a different reality. Specifically, some growth models were unbalanced with excessive dependency on exports and misallocation of resources in low-productivity sectors, while complacent governments had largely avoided implementing the necessary structural and institutional reforms to sustain growth. Beginning in 2011, EM equities have lagged the broader global market. EM fixed income held up relatively well until 2013, when a “blind” search for yield was replaced by a more cautious assessment of EM economic and institutional weaknesses.

Are EM Undergoing a New Cycle of High Volatility and Frustrating Returns?

Hardly. We do not see the conditions for repeat of a 90s-like crisis. Most of these economies and their financial markets have progressed materially since that flammable period. Looking at the recent flows to EM and their debt structure, we see more encouraging signs relative to those observed during the Latin American and Asian crisis of the 90s. Back then, most of the funding to EM came from a few financial institutions, mostly U.S. and European banks, with leveraged balance sheets. Instead, recent investments have been coming from a much more diversified investor base, including corporations for Foreign Direct Investments (FDI) and non–leveraged retail and institutional funds.

Capital Flows to Emerging Markets

Source: IMF, Financial Stability Forum, April 2014. Other investment covers short- and long-term trade credits; loans (including use of Fund credit, loans from the Fund, and loans associated with financial leases); currency and deposits (transferable and other—such as savings and term deposits, savings and loan shares, shares in credit unions, etc.); and other accounts receivable and payable. Transactions covered under direct investment are excluded.

In our view, this has two main implications for today compared to the 90s:

  1. The predominance of non-leveraged investors signals a lower vulnerability of these markets to forced selling in the event of a sudden crisis. However, it does not completely insulate EM from changes in investor sentiment, which typically happens in risk on/risk off blips.
  2. Another relevant difference is the EM debt structure. In the mid-90s, a significant part of sovereign EM debt outstanding was denominated in dollars. This proved to be a significant cause of instability, as mismatches between revenues in local currencies and liabilities in dollars became unsustainable in times of crisis, amid currency depreciation and outflows. Now, the situation appears materially different, as local-currency sovereign debt accounts for about 80% of total sovereign debt. In addition, the currency composition of external debt instruments is more local.

EM – Not Completely Immune from Crises but on a More Solid Foundation Than in the 90s

We are not saying that EM are completely immune from crises. The increasing role of global portfolios and the proliferation of a broad spectrum of investment vehicles ensure that EM are closely intertwined with global financial conditions. Today EM are sensitive to the effects of normalization in monetary policies, especially in the U.S. The effects of an unwinding of current monetary conditions may be material and unpredictable, as these policies were implemented through “unconventional” tools (mainly quantitative easing), rather than through the usual lever of interest rates.

Nonetheless, we believe that the evolution of the size and depth of EM financial markets, as well as the improved fundamentals (especially in terms of foreign-currency reserves), has put EM on a more solid foundation than in the 90s. The ability of policy makers to reinforce the financial system and develop a broad base of domestic investors should make them even more resilient.

For a broader analysis on EM, including an analysis of the crucial role China plays in the global economy, read the full Global CIO Letter, Emerging Markets: Setting Up for a Better Future.

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