Emerging Markets Face Mounting Challenges as Global Liquidity Dries Up

Demographic and growth dynamics remain positive, but countries need to improve governance and pursue reform to take advantage.


The most challenging times for investors are when frothy markets turn choppy. As Warren Buffett once explained to Berkshire Hathaway shareholders, you find out who’s swimming naked only when the tide goes out.

Today investors and policymakers in emerging-markets economies know just what he meant. These vibrant countries helped pull the global economy back from the brink of disaster with their quick recovery from the recession that followed the collapse of Lehman Brothers Holdings in 2008. China used massive stimulus to get growth back near its torrid precrisis pace, bolstering global demand for everything from iron ore to iPads. Countries like Brazil and Russia prospered from the boom in commodity prices. Investors fleeing near-zero interest rates in Western economies sent record amounts of money to developing countries, spurring an epic stock market rally. The MSCI Emerging Markets Index gained some 150 percent between February 2009 and April 2011.

In recent months, however, the mere hint of a tapering of bond purchases by the Federal Reserve Board has altered the calculus of global investing and put emerging-markets policymakers in the hot seat. Investors have rushed for the exits, pulling more than $47 billion from emerging markets since May, according to fund tracking firm EPFR Global, causing stock markets to swoon and interest rates to climb. The MSCI Emerging Markets Index lost 5 percent of its value in one week in mid-August on jitters about rising U.S. interest rates, bringing its decline for this year to more than 15 percent. Over the same period the S&P 500 gained 15 percent and the Euro Stoxx 50 index rose 6 percent.


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The impact on emerging-markets currencies has been even greater. Brazil, India, Indonesia, South Africa and Turkey have all seen their currencies drop by more than 10 percent this year. They have adopted measures including rate hikes (Brazil, India, Indonesia and Turkey), market intervention (Brazil and India) and import restraints (Indonesia) in an attempt to stanch the flows. Overall reserves of developing countries fell in June and July, the first time that’s happened since 2009, according to analysts at Morgan Stanley. Indonesia’s reserves plunged by $20 billion, or 18 percent, to $92.7 billion in the first seven months of this year.

Christine Lagarde, managing director of the International Monetary Fund, endorsed the protective measures at the Federal Reserve Bank of Kansas City’s annual symposium at Jackson Hole, Wyoming, late last month but warned that countries needed “further lines of defense,” including central bank swap lines and IMF assistance.

The prospect of a change in Fed policy after five years of unprecedented monetary ease is daunting. Investors with long memories will recall that U.S. monetary tightening helped trigger both the Latin debt crisis of the 1980s and the Asian financial crisis of the late 1990s. The roots of the recent tensions extend far beyond the level of U.S. interest rates, however, and reflect a deterioration in economic fundamentals across much of the emerging-markets world.

China’s growth rate has decelerated steadily from 10.4 percent in 2010 to a 7.5 percent year-on-year gain in the second quarter of this year. To an extent, the slowdown is expected: China has become too rich to continue to grow at double-digit rates based on low-wage manufacturing. The country is in the midst of trying to reorient its economy from an export-driven dynamo into one fueled much more by domestic consumption — a tricky transition that may be anything but smooth. In addition, many analysts and investors worry that the country’s $586 billion stimulus program may have left a legacy of bad-debt problems at China’s big banks. (See also “Can China and Russia Escape the Crisis?”)

The Legacy of Lehman: A Look at the World 5 Years After the Financial Crisis

With the Chinese juggernaut slowing, Brazil, Russia, South Africa and other raw-materials exporters can no longer count on steadily rising revenues. Prices for oil and copper both increased fivefold between 2000 and 2008. Since China started losing momentum, in the spring of 2011, the price of oil has dropped by 15 percent and copper by 30 percent. Such declines are among the main reasons growth has slowed to a near standstill in Brazil and Russia.

In addition, many countries are feeling the effects of losing their zeal for growth-enhancing economic reforms — or of never having had an appetite in the first place. India let its economic liberalization efforts lapse for several years, and although Prime Minister Manmohan Singh recalled Palaniappan Chidambaram to the Finance Ministry in 2012 with a mandate to contain the budget deficit and open up the country’s retail sector, that hasn’t been enough to stem the economic decline. India, along with Indonesia and Turkey, also let its current-account deficit widen sharply. Those deficits, once easily financed, are now spooking investors as the flow of easy money dries up.

Many developing countries continue to suffer from corruption and poor corporate governance. Only one major emerging market, Chile, ranks among the top 40 countries on the 2012 Corruption Perceptions Index, published by Transparency International, a Berlin-based governance advocacy group. Investors have been burned repeatedly by emerging-markets companies whose results didn’t live up to the hype, such as Sino-Forest Corp., which filed for bankruptcy after an accounting scandal, and OGX Petróleo e Gas Participações, the Brazilian oil company that is seeking to restructure its debts after failing to meet the bold production promises of owner Eike Batista.

All of these factors have coalesced to cast doubt on the idea, prevalent just a year ago, that the future belonged to emerging markets. Bridgewater Associates, the $145 billion Westport, Connecticut–based hedge fund firm, predicts that the advanced countries — a group that includes the U.S., Western Europe and Japan — will add more to global growth this year than emerging-markets economies, something that hasn’t happened since 2007.

To be sure, the emerging markets are not about to collapse. These countries are still expanding much faster than the developed world in percentage terms, and corporate executives continue to focus on them as a source of the next generation’s profits. The population of emerging-markets countries is projected to grow by 2.4 billion by 2050 while that of developed countries plateaus near current levels, according to the United Nations’ World Population Prospects report. And even if larger countries are seeing their growth rates slow, a new wave of frontier markets, such as Colombia and Nigeria, are developing rapidly and providing new opportunities for investors.

“From where we sit there is still a very high level of optimism about the BRICs [Brazil, Russia, India and China] and other markets, like Turkey, Indonesia or Mexico,” says Yuval Atsmon, a London-based principal in the strategy practice at McKinsey & Co. “China and India accounted for half of global GDP before the 18th century, and they are heading back to their rightful place now.”

Most emerging-markets countries have greater resources for confronting today’s difficulties than they had in the past, thanks to years of growth and record reserve accumulation.

“It’s amazing to think that Russia defaulted in 1998 because it could not raise $5 billion, and 15 years later our reserves are $500 billion,” Anton Karamzin, deputy chairman of the country’s largest bank, Sberbank, tells Institutional Investor.

Nevertheless, emerging markets face a much greater challenge in trying to sustain the progress made over the past two decades.

THE RISE OF EMERGING-MARKETS economies over the past two decades has been truly historic. China and India have both doubled their GDP twice since 1990 — something that took England 150 years to achieve during the Industrial Revolution, notes McKinsey’s Atsmon. England started its rise to economic preeminence with a population of about 10 million; China and India have done so with a combined population of more than 2 billion, lifting more people out of poverty in a shorter period of time than ever before. Developing countries’ share of global economic output has nearly doubled since 2000, to 31.7 percent last year, according to the World Bank. On a purchasing power parity basis, their share rises to 43 percent.

This prodigious expansion was bound to slow down, if only from a mathematical point of view. “There need not be a middle-income trap, but there is inevitably a middle-income deceleration,” says Ruchir Sharma, chief of emerging-markets equities at Morgan Stanley Investment Management and author of the book Breakout Nations: In Pursuit of the Next Economic Miracles. “The most important thing about China is to realign expectations for 5 or 6 percent growth over the next five years.”

Other factors are reining in yesteryear’s tigers. The past two decades of unprecedented wealth creation have adversely affected competitiveness, especially in China. Average Chinese wages increased by 17 percent a year in dollar terms from 2000–’12, according to research by Sammy Suzuki, portfolio manager for emerging-markets core equities at AllianceBernstein. That largesse was outdone only by Russia, where average pay climbed by 23 percent a year. Most of China’s Asian neighbors held their workers to single-digit annual wage hikes over the same period. By contrast, Mexico doled out annual raises of just 0.4 percent. Looking at those numbers, it’s no wonder that China’s leaders have set a goal of shifting away from export-led growth.

Russia and Brazil have tried to counteract softening commodity earnings by using consumer credit to boost spending, but both have had to put on the brakes, fearing inflation and bad-debt problems.

The best path forward for these countries, says Sharma, is the one blazed by Japan, which reached middle-income status in the 1970s, and followed by South Korea and Taiwan, which hit that milestone in the 1980s. These countries moved to the top of the value-added chain and created world-beating companies like Toyota Motor Corp., Samsung Group and Taiwan Semiconductor Manufacturing Co. China seems to be the best positioned of the BRICs for this transformation; Russia, with virtually no globally competitive products except for raw materials and weapons, the worst.

Success has become a problem for many rising economic powers in another way: It has made their leaders complacent and resistant to change. Consider the role of large state-owned companies and banks. In the 1990s the U.S. and the IMF urged developing countries to privatize wide swaths of their economies as part of market-oriented reforms, but the so-called Washington Consensus has lost credibility as the U.S. and Europe have struggled with self-inflicted economic wounds, while China’s rise has increased the appeal of state-led capitalism. In recent years privatization has ground to a halt in many countries.

The renewed prominence of state-controlled companies has been anything but beneficial for these economies. Companies with at least 30 percent state ownership account for roughly one third of the emerging markets’ collective $9 trillion market capitalization, and their value has dropped by a stunning 40 percent over the past five years, according to calculations by Morgan Stanley’s Sharma.

Industrial and Commercial Bank of China and China Construction Bank Corp., both state-owned, top this year’s Forbes Global 2000 list of the world’s largest corporations. They are among the world’s most profitable banks, but stocks of both have performed poorly because of investor worries about bad-debt problems. ICBC’s shares have fallen by 11 percent since August 2010, while CCB’s have declined by 12 percent. Petróleo Brasileiro and Gazprom are by far the largest companies in Brazil and Russia, respectively, but their exploration efforts have failed to produce much in the way of production gains, and their stock prices have fallen by more than half since April 2011. “If you could get some visible improvements at a company like Petrobras or Gazprom, it would really push the whole market,” says Tim Seymour, managing partner at Triogem Asset Management, a $300 million New York hedge fund firm that focuses on emerging markets. He is not holding his breath, though.

Broader systemic reforms have slowed, if not ground to a halt, across the leading emerging markets, and corporate governance scandals remain regular occurrences. Shares in a dozen or so publicly traded Chinese companies collapsed as a result of accounting irregularities in 2010 and 2011; Sino-Forest, whose capitalization peaked at $6 billion, filed for bankruptcy protection in Canada in 2012 following claims that it had exaggerated its timber holdings in China. Those scandals have been a major factor in the nearly 35 percent drop in China’s CSI 300 index since the end of 2009. In October 2011 the Securities and Exchange Board of India reported an “elaborate scheme to manipulate markets” involving the conversion of Luxembourg-listed global depositary receipts of 17 different companies into domestic shares at arbitrary multiples. In July, Brazil’s securities regulator launched an investigation into allegations of insider trading at OGX after owner Batista sold a chunk of shares shortly before the company issued a warning about its oil output prospects.

The official response to these scandals has been minimal, investors say. “Corporate governance is not getting better anywhere in the world,” says Mark Mobius, executive chairman of the emerging-markets group at Franklin Templeton Investments.

Corruption is not getting better, either. Out of 178 countries in Transparency International’s 2012 Corruption Perceptions Index, the BRICs ranged from 69th place (Brazil) to 133rd (Russia) — a little worse, on average, than their scores five years earlier.

The combination of slower growth and endemic structural problems is proving toxic at a time when prosperity has lifted popular expectations in much of the developing world. This summer in Brazil local protests against higher bus fares in Rio de Janeiro and São Paulo quickly metastasized into nationwide demonstrations over inequality and the alleged extravagance of government spending on the 2014 FIFA World Cup and the 2016 Summer Olympic Games. In Turkey government plans to bulldoze a central Istanbul park to erect a mosque and shopping center sparked broader protests against the perceived authoritarianism of the government of Prime Minister Recep Tayyip Erdo?gan; the unrest contributed to a 25 percent drop in the Istanbul stock market.

“If people’s income is not increasing as fast as it was before, they are going to pay more attention to those who are getting richer faster than they are,” McKinsey’s Atsmon says. “We can’t predict how that will play out.”

All these negative factors will come into play more prominently if the Fed reduces its bond purchases this autumn and the massive wave of liquidity that has lifted global markets begins to recede. Cumulative net capital flows into emerging-markets bonds have risen by $1.1 trillion since 2008, exceeding the long-term structural trend by an estimated $470 billion, according to the IMF’s Lagarde. Overall net inflows, including equities and foreign direct investment, have been running at a rate of more than $1.1 trillion a year since 2010. If the reversal of flows reaches anywhere near that magnitude, it is likely to affect everything from growth rates to stock prices to the availability of consumer credit across much of the developing world.

The emerging-markets story is hardly over, though. The BRICS may have slowed significantly, but a number of other markets, most of them at a much earlier point on the development curve, continue to generate strong growth and investment gains.

“We are looking for places with a catalyst for positive change, usually a new leader who comes to power after a bad decade or two,” says Morgan Stanley’s Sharma.

The Philippines is a prime example. Since taking power in 2010, President Benigno Aquino III has pushed fiscal and agricultural reforms that have strengthened the country’s finances and narrowed income inequalities. He has promoted the country as a location for call centers and business outsourcing. The results have been impressive: The economy expanded by 6.4 percent last year and is on track for a similar performance this year. The Philippines achieved a milestone in May when Standard & Poor’s gave the country an investment-grade rating for the first time.

Investors have also flocked to Nigeria, where President Goodluck Jonathan has overseen growth rates above 6 percent since his election in 2011 and developed a blueprint for ambitious, pro-market reforms in the power and agricultural sectors. Markets have responded: The Nigerian Stock Exchange All-Share Index shot up 54 percent in the 12 months to August 29, to 36,400.38.

“What’s really new since 2008 is the emergence of the frontier,” says Franklin Templeton’s Mobius. “It’s like 1987 all over again. We are flying around the world setting up brokerage and custody arrangements. It’s very exciting.”

Many frontier markets are actively courting international investors and pursuing governance reforms and market-oriented policies. “Almost anywhere you go around the world, you are going to find a competent finance minister and central banker. That just wasn’t the case 15 years ago,” says Lado Gurgenidze, former prime minister of Georgia and now chairman of gboth Georgia’s Liberty Bank and Bank of Kigali in Rwanda.

Risk is definitely back in emerging markets, but a next generation of rewards beckons. • •