Are Emerging Markets Striking Back, or Out? The View from Investors

At the start of the Wharton Global Alumni Forum’s June 9 panel on investing in emerging markets, Assaad Jabre, former vice president of operations and acting executive vice president of the International Finance Corporation, offered a succinct view of the future: “Emerging markets will be the winner of the globalization process,” he stated. “A few years ago, many people were saying that developing countries would be the victims. We know that won’t be the case. China, India, Turkey and others are success stories.”  One major reason for this development, he said, “is the growth of the private sector in those countries. I was in China a few months ago at a seminar on privatization organized by the government. That would have been impossible 15 years ago.”

Private sector involvement today is changing how these countries operate, he noted. Indeed, 45% of the aggregate GDP in the world today comes from emerging markets.

Ironically, the panel discussion took place during what turned out to be a big decline in stock markets throughout much of the developed and developing world. In addition to a 3.2% drop in the Dow Jones during the week ending June 10, major stock indexes dropped in Hong Kong, Bombay, Mexico City, Seoul and London.

Investment strategists cited a number of reasons for the sell-offs, such as worries about higher inflation along with fears that the U.S. Federal Reserve will raise interest rates during its next policy meeting June 28-29, a move that can act as a brake on economic growth. In addition, when investors start to panic, they tend to pull back on their riskier investments, including those in emerging markets. Analysts, however, were also cautioning against an overreaction to the stock market declines, noting that the major indexes are still up for the year. “Even in the emerging markets, which have had big surges and fallbacks, the fundamentals remain largely intact,” one commentator said.

The panel, entitled “Emerging Markets Strike Back,” was moderated by Wharton finance professor Bulent Gultekin, former governor of the Central Bank of the Republic of Turkey. In addition to Jabre, panel participants included Harry Alverson, managing director of The Carlyle Group, who is responsible for investor relations and fund formation in the Middle East and Europe; Tezcan Yaramanci, chairman of Bank Europa Turkey; Yavuz Canevi, chairman of TEB-BNP, a privately-owned Turkish commercial bank; and Yosef Shiran, CEO of Israel-based Tefron, a manufacturer of active wear performance apparel.

Record Amounts of Money

The Carlyle Group’s Alverson noted that the origin of the term “emerging markets” goes back to 1952 when a French academic decided to divide the world into three categories: The first was the industrialist capitalist countries, the second was the industrialized communist countries, and “the third was the ‘Third World,’ that 75% of the world’s population which did not fit into the first two categories.” The term was in common usage until 1981 when the World Bank and International Finance Corp. (IFC) decided to form a “Third World Equity Fund” to focus on this area. During a presentation to bankers by Salomon Brothers, which had been hired to market the fund, a representative from JP Morgan objected to the term ‘Third World,’ saying it would be hard to sell a fund with that name. “So the World Bank dreamed up the term ’emerging markets,’ which has been in common usage ever since,” said Alverson. “But it was a euphemism for ‘Third World’ and it was basically a marketing tool to help sell the IFC’s fund.”

The “ultimate 19^th century emerging market was the U.S.,” Alverson added, and “many people think the ultimate 20^th century emerging market was Japan.” From 1955 to 1960, it experienced 10% average annual growth, faster than any other country, and exports increased 15% per year during that decade. “Japan was put on the investment map.”

Now, in the 21^st century, “it’s not clear there is a single dominant emerging country, although China could become that,” said Alverson, who, prior to joining The Carlyle Group in 1996, spent 13 years with Bankers Trust responsible for Middle East corporate finance. “But within the universe of emerging markets, we believe they are being bifurcated into two — emerged and emerging. The emerged markets will continue to receive the bulk of capital and investment, and most importantly, when the next economic dislocation occurs, these markets will fare much better than the other emerging markets.” The emerged markets include China (stock market capitalization, $286 billion), India ($553 billion), Brazil ($475 billion), Russia ($330 billion), Mexico ($239 billion), Korea ($718 billion), Taiwan ($476 billion) and South Africa ($549 billion).

The characteristics of these emerged private equity markets, said Alverson, include governments that are favorable to private equity investing, global private equity firms that are already active, GDP in excess of $500 billion, visible private equity exits that have occurred, and the availability of debt from local banks or transactions.

Alverson went on to cite a second group of 15 countries that “we believe are emerging in the next five to 10 years.” The first eight include Turkey (stock market capitalization, $162 billion), Thailand ($124 billion), Argentina ($48 billion), Poland ($94 billion), the Philippines ($40 billion), Saudi Arabia ($650 billion), Egypt ($80 billion) and Malaysia ($181 billion). The others include: the Czech Republic (stock market capitalization, $35 billion), Chile ($136 billion), Hungary ($33 billion), Nigeria ($22 billion), United Arab Emirates ($132 billion), Kuwait ($294 billion) and Jordan ($38 billion). Saudi Arabia, Kuwait and the UAE have stock market capitalizations significantly larger than GDP, he noted. (GDP in these countries is $338 billion, $45 billion and $111 billion, respectively.)

Alverson questioned whether investors are ignoring the track record in these emerging markets, pointing out that on average, emerging market private equity funds have underperformed when compared to Europe and the U.S. The average 10-year returns for emerging markets as of September 2005 were 3%; for Europe, 10.9% and for the U.S., 13.8%. “Emerging market results continue to compare unfavorably relative to the U.S. and Europe,” he said.

What, Alverson asked, are investors doing in response to this data? “They are pouring record amounts of money into these emerging markets. There has been a dramatic increase in the Middle East,” he said, noting that in May 2006, $1 billion in six private equity funds was announced, while Asia Private Equity News has tracked 75 Middle East funds totaling about $35 billion in equity capital.

Recent activity in Turkey alone includes Kohlberg Kravis Roberts’ $200 million bid in May for a 30% stake in department store Boyner; AIG Capital Partner’s investment in retailer For You Bakim Unrunleri Magazalar, a fast-growing discount retailer, also in May; and Texas Pacific Group’s $900 million acquisition in April of spirits producer Mey Icki, the maker of raki, Turkey’s most famous drink.

“Despite substandard returns, money continues to flow into emerging markets at a very fast clip,” Alverson said. Reasons include “high economic growth rates, the opening up of stock markets, the increasing globalization of investors, the empowerment of individuals through the Internet, excess capital to invest, over-competitive Western markets, and the availability of debt to finance these transactions.”

An audience member asked Alverson whether the fact that most of the businesses in Turkey are owned by families creates difficulties for a private equity fund used to dealing with public companies. How does this factor into making a private equity deal in Turkey?

Although The Carlyle Group has some portfolio companies with joint ventures in Turkey, Alverson said, the company currently is not very active in that country. But on the general question of structuring deals, he noted that Carlyle’s investor base “is indifferent as to whether we invest in big companies, small entrepreneurial companies or large public companies. They trust us to find the best opportunities for them … We are driven by rates of return only, looking for approximately 25% per year. We don’t have a social agenda.”

Alverson added that in the past, the returns in emerging markets “have been dismal… but going forward, the expectation is that, because of growth rates and extreme competition in Europe and the U.S. where many, many dollars are pushing valuations up, it’s getting much harder to make higher rates of return. So we are prepared to take risks by going into places like Asia, India, maybe the Middle East and Latin America. In the past, performance has not justified those risks.” 

Asked how long he expected emerging market opportunities to be sought out by companies like Carlyle, Alverson responded that, “given the current level of liquidity sloshing around the world, I think the trend will continue a long time. And private equity funds’ amounts devoted to emerging markets, while small, mount up. Just allocating one or two or three percent into emerging markets adds up to large markets.” In the overall emerging markets private equity area, fund managers raised $21.2 billion in 2005, 245% above the 2004 level of $6.1 billion, according to data from the Emerging Markets Private Equity Association.

Alverson was also asked why The Carlyle Group left Russia. His response: “No doubt there is money to be made in Russia, and we have taken a couple of stabs investing there. But once we [looked around], we concluded it wasn’t easy to develop the kinds of transactions we wanted, and we didn’t think we had a compelling story to sell to investors. In addition, the fundraising was harder than we thought. If we could have developed some interesting transactions on the ground, the investors would have followed. We had a tough time and decided to cut our losses. Also, in our opinion, Russia is not really ready for prime time. There are capricious changes in tax regulations that have confounded companies like BP, not just Yukos, that suddenly find themselves being assessed retroactively for taxes, and so forth. We did not want to expose our investors to those types of risks. But I wouldn’t be surprised if we made another attempt at investing in Russia in the not too distant future.”

A Love-Hate Affair

Yaramanci, Bank Europa’s chairman, began his remarks by noting the incongruity of the panel’s title given that in the past two weeks a substantial amount of funds had moved out of emerging markets, “creating serious headaches for the countries they left.” Turkey, he noted, “is one of the major victims … I doubt whether the emerging markets are striking back or whether they are receiving another strike.”

Yaramanci spent 1968 to 1991 at the Koc Group, Turkey’s largest business conglomerate. In 1992 he joined the government sector and was appointed president and CEO of Turkish Airlines. In 1994, he was appointed president of the Public Participation Administration, a group responsible for the financing of major infrastructure projects and the privatization of state-owned enterprises.

In Turkey over the last 15 days, he said, almost $10 billion U.S. dollars have flowed out of the country, “which leads me to conclude that the relationship between excess liquidity in the world and the emerging markets is perhaps a love-hate affair. On the one hand, excess liquidity is in search of investment opportunities. Naturally the demand for higher yield is always there. What limits that desire is its risk. [Investors] finally find an equilibrium where the reward fits the risk, and they go to places where they can find these rewards.”

Meanwhile, less developed, “finance-hungry economies are prepared to pay these higher rewards, which a more developed mature economy is not prepared to pay. So now the love affair starts. Investors looking for better and better opportunities go to these places, being very careful not to stay there a long time, but just to harvest [their gains] … They will leave at the first small sign of problems. That is normal from an investor’s point of view, but uncomfortable for the market.

“Sometimes I think the expression ’emerging market’ is a polite way to say ‘lucrative opportunity,'” said Yaramanci. “But this play will go on.  It is up to the emerging markets to get out of this [relationship] by distinguishing between the attractions they must provide to financial investments, and the attractions they must provide to foreign direct investments (FDIs). FDIs are not as mobile as financial investments, so they remain during crisis times and they help to develop and strengthen the economy. An emerging market should give extra attention to FDIs and provide them with a proper climate so the benefit will be long term for the country.”

Panelist Yavuz Canevi, TEB-BNP’s chairman, was governor of the Central Bank of Turkey in the mid 1980s and in 1986 was undersecretary of the Treasury and Foreign Trade. During his remarks, he stated that over the next few years, “we are not assuming a crisis; we are relatively optimistic as to global developments.” Part of that optimism stems from how far Turkey has come since the 1990s, an “underperforming decade,” as Canevi described it. “There was high chronic inflation, high interest rates, a large public sector deficit, poor fiscal discipline and coalition governments every 18 months,” not to mention three economic crises and one natural one (an earthquake).

And then, in 2002, “we hit back with a very strong crisis management program put together by the coalition government. We had some new blood, a fiscal correction, tight monetary policy, corporate restructuring and banking reform.” The results were very positive, Canevi said, “and Turkey has entered into a steady growth period with a level of progress not seen for 30 years. Exports boomed, productivity increased, and we established a strong link with the European Union and have started official negotiations for full membership.”

A robust global environment did its part as well, including global disinflation and abundant global liquidity. “Turkey was a big beneficiary of that,” Canevi said, adding, however, that “what was most desired but not achieved was employment. Although we had 7.6% growth [in 2005], people are not seeing it reflected in the employment side.” Where, he asked, are the job opportunities? “All corporations tried to be cost conscious, and there was increasing productivity and increased imports. But this didn’t help create new jobs.”

Consequently, “the situation is not as rosy as it seems, given that we have the high cost of social security reform, high unemployment, an informal economy that is hurting our competitiveness, political tensions and external concerns like the avian flu, Iran, Syria, and Iraq.” These are factors “we cannot control and that are due to Turkey’s geography. … The challenge is to establish a long-term game plan, set up priorities and manage the EU process properly. Turkey is prepared to cope with these challenges but it will not accept marginalization within the EU,” Canevi said.

Asked about the presence of merchant banking and whether that type of financing will develop over the next few years, Canevi noted that merchant banking does not yet exist in Turkey “because of the culture of private ownership in the corporate sector.” If one tried to do merchant banking, one would find “no market in front of you and no client base that will go ahead with you. [Potential clients] say, ‘I can go to my bank and get necessary financing. I don’t need an investment bank or merchant bank to help me out.'” Also, high inflation and interest rates until recently have discouraged this type of activity, he added.

Risks of a Global Operation

Panelist Yosef Shiran, CEO of Tefron, talked briefly about ways in which a company based in the Middle East can compete against the Far East in the textile market.

Tefron is based in Misgaz, Israel, has about 2000 employees and reported sales of $205.6 million in 2005. It operates high tech production facilities in Israel and Jordan, and has established relationships in China, Cambodia, India and Turkey, including a recently signed joint venture with a Turkish socks manufacturer. It makes seamless intimate apparel, activewear and swimwear for such customers as Nike, Patagonia, Victoria’s Secret, The Gap, Banana Republic, Target, Warnaco/Calvin Klein, Reebok and El Corte Englese, reflecting the company’s mission to be “a strategic partner for the world’s premier apparel brands.” A month ago, the company launched a joint Center of Excellence with Nike, in its Beaverton, Ore., headquarters, to focus on integrating the latest textile technology with innovative apparel design. The alliance is expected to help the two companies respond more quickly to market trends.

“As part of our global operations strategy,” said Shiran, “our production location is determined by the following factors: cost-effectiveness; quick response cycles; vertical manufacturing capabilities; proximity to markets; tax, duty and quota considerations, and the local business culture.” 

Given that framework, Shiran cites the advantages of producing in the Middle East and Turkey. Among these is geographic location: Because Turkey is a portal to both Europe and Asia, the transportation time necessary to ship goods to those markets is reduced. “Quick response time and proximity to our markets are important, and it is one reason we formed a joint venture in Turkey,” he notes. There is also the combination of low labor costs (in Jordan and Egypt), advanced technological capabilities (in Israel), and vertical manufacturing capabilities in Israel, Egypt and Turkey. 

The risks of a global operation include competing trade agreements, such as the Sri Lanka-Europe duty-free quota-free agreement, along with growing technological capabilities and manufacturing capacity in the Far East. “In addition, because of shorter, more direct routes and faster ships from China to the Western world, there are disadvantages to selling into the growing Asia market from here,” Shiraf said. “The Middle East market is good for Europe and the U.S. but it doesn’t work to sell into Asia. The solution is joint ventures in China, which we formed recently,” and in other parts of the Far East.

Tefron also makes use of the Jordan QIZ (Qualified Industrial Zones) for exporting to the U.S. and soon to Europe. QIZ allows goods manufactured in these zones to enter the U.S. duty free and quota free, thus encouraging international manufacturers to move their industries to these areas. Shiraf noted that the production cost of one sport top manufactured in Israel alone is $12; in Israel and Jordan, $10; and in China, $8, plus an additional 29% due to duties and quotas.

Panelist Assaad Jabre, while bullish on emerging markets overall, tempered his enthusiasm by noting that these markets continue to be defined by a number of vulnerabilities, four of which are particularly “worrisome.”

First is the growing inequality visible within developing countries. “Economic growth has done wonders to reduce poverty around the world, but it also raises tensions,” he said, adding that the number of ‘social incidents’ in China increased from 10,000 in 1994 to 80,000 in 2004. Inequality among developing countries themselves is another concern, with emerging global economic powers like China and India at one extreme, and Africa and Central Asia at the other extreme.

The second big vulnerability has to do with the environmental implications of accelerated growth in developing countries, Jabre said. China is “showing leadership in this area and is trying to go for a more balanced approach to growth,” although, according to numerous press reports, the country’s air and water pollution problems have grown particularly acute over the past 25 years. Jabre’s third and fourth concerns include weaknesses in the regulatory framework and corporate governance — because of this, “there is volatility all over, but especially in emerging markets, where the business environment tends to be more strongly affected” — and the risk of protectionism.

Given this analysis of emerging markets, Jabre called on governments to actively pursue more privatization. “The problem is lots of liquidity but not enough creditworthy transactions. There must be a greater effort to create more good deals. Governments cannot be held responsible for everyone. The corporate sector has an important role to play in this area as well as in the area of corporate governance.”