During bouts of financial turbulence, emerging markets have typically been the first to suffer. Sharp currency moves, interest rate spikes or liquidity crises usually spark a flight to quality, benefiting the dollar and U.S. Treasuries and slamming equity and bond prices in developing countries. But as the blowup of the U.S. subprime mortgage market spread panic through capital markets recently, a curious thing happened: Investors for the most part kept their nerve -- and their positions in emerging markets.
Welcome to the new world of global investing. Ten years after the Asian currency crisis triggered deep recessions across the region and turmoil throughout world markets, emerging markets are serving as a source of stability rather than contagion. Sound policies and strong economic fundamentals have left these countries better placed than ever to ride out the subprime-spawned credit storm. Just so, emerging-markets securities have gone from being a niche opportunity for high-risk investors to a core holding of even the stodgiest of pensions funds. Far from being an anomaly, the newfound strength and stability of emerging markets are here to stay, many investors and analysts believe.
"A decade ago these countries were loaded with debt and low foreign reserves that were vulnerable to interest rate swings," says Gunter Heiland, managing director and co-head of J.P. Morgan Investment Management's emerging-markets debt team. "Now they've got low inflation and strong economic growth, and they've taken advantage of the tailwind from high commodities prices to shore up their finances. From the standpoint of fundamentals, some of these markets are safe havens."
The most dramatic example is China. The country is not only enjoying the world's strongest growth rate -- a torrid 11.5 percent in the first half -- but its market is also heavily insulated from global capital flows by rules that limit direct foreign investment in Chinese stocks to just $10 billion, or 1 percent of the market's capitalization. The net result: While the Hang Seng China enterprises index of leading Chinese stocks listed in Hong Kong dropped 18.4 percent in the three weeks when the subprime fallout was at its worst, the CSI 300 index of leading stocks in Shanghai and Shenzhen rose 13.4 percent, bringing its gain for the year to a cool 113 percent. And after Beijing announced late last month that it would allow mainland investors to invest in Hong Konglisted China stocks, the Hang Seng China enterprises index surged 16.9 percent in a week and was up 35.3 percent from the start of the year.
"The thinking in China is, 'The world's got problems, but our economy is growing as fast as it has ever done, there's still lots of money, sentiment is strong, and we've got the Olympics next year,'" says Fraser Howie, head of structured products for CLSA Asia-Pacific Markets in Singapore. "It's full speed ahead."
Emerging markets are not without vulnerabilities, of course. These economies will feel the effect of any U.S. economic slowdown, even if they have reduced their dependence on American consumers. And one of the consequences of being a more mainstream asset class is that investment funds facing a liquidity squeeze can readily unload emerging-markets securities.
Emerging markets have homegrown weaknesses as well. Inflation pressures building in China and India could force authorities to tighten monetary policy. Indeed, the People's Bank of China last month hiked its benchmark one-year lending rate by 18 basis points, to 7.02 percent. The hike was modest, but it was the fourth increase so far this year. Chinese banks also are sitting on an enormous reservoir of bad loans that could derail the financial sector.
"Linking U.S. credit issues and emerging markets directly is difficult," says Tim Cook, president of Kailas Capital, a Stamford,
Connecticutbased hedge fund. "But there are other problems, particularly in Asia, that could come to the fore at some point."
Rich valuations are also a concern, especially in China. The country's CSI 300 index was up 157 percent from the start of the year in late August, and the average stock was trading at 38 times estimated 2007 earnings, compared with multiples of 22 times earnings for Hong Kong stocks and about 15 for stocks in the Dow Jones industrial average.
To be sure, emerging-markets equities did get caught up in the global wave of selling in late July and early August. The MSCI emerging markets index fell 8.88 percent in the month to mid-August, compared with a decline of 5.55 percent for its EAFE index of developed markets in Europe and Asia and a drop of 3.36 percent for its U.S. index. The reaction was much more modest than in previous bouts of financial turmoil, however.
The subdued response of emerging-markets bonds was equally telling. The yield spread on JPMorgan's EMBI index of emerging-markets bonds relative to U.S. Treasuries widened to 257 basis points in mid-August, a rise of 79 basis points from a month earlier. But the spread remains remarkably low by historical standards. The EMBI spread surged by more than 800 basis points, to as high as 16 percentage points, following the near-collapse of Long-Term Capital Management in 1998.
The declines in emerging-markets bonds and equities largely reflect general uncertainty over the extent and location of U.S. subprime losses rather than any fundamental concerns, says Jerome Booth, head of research at Ashmore Investment Management in London, which manages $31.6 billion in emerging markets. "If there is a clear location of the problem spot, you'll see a recovery in a timely way," he predicts.
There is some direct exposure to the subprime crisis in emerging markets, but not enough to worry most investors. Bank of China last month disclosed holdings of $9.7 billion of securities backed by subprime U.S. loans and took a provision of 1.15 billion yuan ($152 million) to cover possible losses. The provision was a fraction of the bank's earnings, though, which rose 51 percent to 29.5 billion yuan in the first half. Industrial and Commercial Bank of China said it held $1.2 billion of securities linked to U.S. subprime mortgages. "To say that subprime is going to affect China even at the margins is an exaggeration," says Peter Alexander, head of Shanghai-based fund management consulting firm Z-Ben Advisors.
The long-term outlook for emerging markets is positive for a number of reasons, not least the dramatic improvement in economic fundamentals. Many countries, particularly in Asia, have slashed debt and built up reserves to reduce their vulnerability to crisis.
The value of emerging-markets sovereign debt has declined to 38 percent of aggregate GDP from 63 percent in 1997, according to economists at JPMorgan; the percentage of debt that carries an
investment-grade rating has risen fourfold, to 40 percent, in that period. China's $1.3 trillion in reserves is the most notable example of reserve growth, but not the only one; across Asia reserves have risen to 8 percent of GDP, on average, from 1 percent a decade ago.
South Korea recovered spectacularly from its 1997 collapse by draining a swamp of underperforming bank loans and diversifying its export markets away from the U.S., generating some $240 billion in hard currency along the way. Brazil and other Latin countries are enjoying unprecedented currency stability as a result of booming commodity exports and record reserve accumulation. Energy-rich Kazakhstan was able to pay off an eight-year-old loan from the International Monetary Fund earlier this year; Brazil retired its IMF debt two years ago.
Demand from China and India, meanwhile, shows little sign of slowing, enabling emerging markets to decouple their fortunes from the U.S. economy. The IMF predicts that this year, for the first time ever, China will be the biggest contributor to global growth, accounting for about one third of a worldwide increase of 5 percent. Economists at Morgan Stanley estimate that developing economies collectively will account for nearly half of global growth this year, compared with just 15 percent for the U.S.
"A lot of investors still regard emerging markets as purely a warrant on the U.S. economy," says Jonathan Garner, London-based head of research at Morgan Stanley International. "We would challenge that view."
Consider China. Its dependence on U.S. consumers has decreased markedly in recent years as the country diversified its export markets. The U.S. now accounts for slightly more than 20 percent of China's exports, down from a peak of about 33 percent in 1999. Countries outside the U.S., the European Union and Japan now take more than 45 percent of Chinese exports, up from 30 percent in 1999.
"China's exports to emerging markets have grown a lot faster than exports to G-7 economies," says Jonathan Anderson, a China economist at UBS in Hong Kong. "That's why the impact of a U.S. slowdown may be limited." He estimates that a 10 percentage point decline in U.S. imports would shave just 0.2 of a percentage point off China's annual growth rate.
As Ashmore's Booth puts it, "even if the U.S. goes into a recession, it's no longer the end of the world."
A U.S. economic slowdown could even help China. "If the U.S. economy slows down and trade demand eases a little bit, that may also ease China's large trade surplus and thus some of the tension in China-U.S. relations," says Gene Ma, president of Beijing-based advisory firm CEB Monitor Group. A drop in U.S. demand also could help authorities in Beijing as they seek to cool the economy's breakneck growth rate and prevent the risk of a surge in inflation.
China's demand, meanwhile, is giving a boost to other emerging-markets economies. Latin American countries, excluding Mexico, generate 6 percent of GDP, on average, from exports to Asia, compared with just 4.8 percent from exports to the U.S. Mexico, by contrast, gets 23 percent of its GDP from exports to the U.S.
In addition to focusing on export diversification, emerging markets are developing their own internal growth engines. China's nonexport-related economy has grown dramatically as Beijing invests heavily in infrastructure projects and services like education and health care. The volume of Chinese retail spending has also skyrocketed as banks introduce such consumer-oriented products as car loans and home mortgages. Private consumption in China amounted to 8 trillion yuan last year, up nearly ninefold from 945 billion yuan in 1990; public spending rose to 3 trillion yuan from 264 billion yuan.
In India consumer lending has grown almost 30 percent a year for the past five years as the country's emerging middle class uses credit to buy everything from washing machines and cars to houses. The McKinsey Global Institute forecasts consumer spending will quadruple to $1.5 trillion by 2025. Morgan Stanley estimates that nearly two thirds of Russia's first-quarter growth was driven by household spending and another third by public consumption.
"Excluding Japan, Asians are buying as many personal computers each year as are Americans," says Morgan Stanley's Garner. "Chinese consumers bought 7 million cars last year, up from only 2 million five years ago. And all this consumption is happening in a low-inflation environment. Not only are emerging-markets fundamentals stronger than they were a decade ago, there's the entirely new element of domestic demand."