The sun is shining brightly at the moment on virtually all the world’s emerging market economies. The MSCI Emerging Markets Index rose nearly 45% in the first nine months of 2007, with the IMF forecasting economic growth rates of 8% or higher, versus 2% to 3% for the OECD nations. It’s been difficult lately to find an emerging market anywhere that hasn’t outperformed the developed world, with spreads on emerging market debt now narrowed to historic levels.
Does all this fair weather for developing markets denote a permanent change in their fortunes? Or is it what the famed American malaprop-ist (and baseball player) Yogi Berra might call “déjà vu all over again?” And will emerging market growth once again implode, as has so often happened in the past?
As participants on a panel titled, “Emerging Markets: Still Emerging?” made clear at the 2007 Wharton Finance Conference, the world’s emerging markets can no longer be evaluated en masse. Whereas economists used to draw a single, crude line between the “developed” and “less developed” countries, noted moderator Roger Leeds, a Johns Hopkins University international finance professor, they have learned to draw finer distinctions — between emerging markets on one hand and, on the other, so-called “frontier markets,” those with even less liquidity and per capita income.
Latin Speed Bumps
Three of the panel’s five participants — investor Emilio Bassini of Bassini & Co., Jorge Mora, a UBS investment banker, and Jamie Nicholson, head of Latin American corporate credit research for Credit Suisse — are Latin American specialists, and their collective views on the Latin economies, though not uniformly bearish, sounded dour.
The much anticipated slowing of the U.S. and European economies will almost surely dampen Latin exports, they noted, as would further weakening of the U.S. dollar. Combine these factors with the lingering challenges that many emerging markets have with political instability and the rule of law, and the results could prove combustible. “I’ve lived through many of these cycles in Latin America,” noted Mora, “and it’s my view that Latin America will cycle back through its problems. With people in power like Hugo Chavez in Venezuela and some of the rhetoric coming out of Argentina, massive speed bumps are inevitable.”
“It’s important to be selective at this point,” agreed investment manager Bassini. Mexico and Brazil have made great strides in the past decade, he noted, but Latin equity markets have a way of reversing themselves quickly, and fixed income spreads are currently too narrow to reflect the attendant risks.
Credit Suisse’s Nicholson was more optimistic, noting that substantial improvements have occurred in many Latin economic indicators, including balance-of-payment positions and the flow of investment capital. “There are significant differences this time,” she argued, pointing to most Latin economies’ improved liquidity and diminished currency risk — Brazil in particular. Meanwhile, she said, the breadth of financing options available to Latin companies has never been better. Until recent years, the only place these companies could turn for long-term financing was the euro-dollar market, where maturities were capped at five-to-seven years. Now, they can access the U.S. market and float longer maturities, while some Brazilian companies have been able to float perpetual bonds that may never need to be repaid.
The emerging market investment environment has, indeed, improved, agreed Jamil Swati of Fortress Investment Group, especially in the area of price discovery. Nonetheless, relatively few emerging market companies have attained sufficient size and maturity to access the public markets, and private equity investors are assuming liquidity and liability risks that seem disproportionate to potential returns. “It’s a very difficult environment, even for seasoned investors,” he said.
The fifth panelist, Eyal Kaplan of Walden Israel Venture Capital, argued that the definition of an emerging market economy is still changing in investors’ minds, as they anticipate declining investment returns for U.S. and Western European companies. A venture capitalist who largely focuses upon early-stage technology opportunities, Kaplan sees the world’s emerging markets continuing to strengthen over time as investors seek promising growth companies wherever they can find them.
Countries with abundant natural resources will experience an economic boom for the foreseeable future,” Kaplan predicted, while China will continue to invest significant amounts of surplus capital in other of the world’s emerging markets. As for Israel, with its ebullient high-tech sector, Kaplan noted, people are already asking whether it’s time to stop labeling it an emerging market and reassign it to the ranks of developed nations.
With so much of the world’s capital chasing investments in the same few countries — Brazil, Russia, India and China, the so-called BRICs — it seems reasonable to wonder if investors aren’t ignoring emerging market opportunities elsewhere. Indeed, Fortress Investment’s Swati noted a growing sense in some quarters that frontier markets like Egypt, the Balkans, Bangladesh and parts of Africa might be the next investment hot spots.
Still, investors are reluctant to venture into places from which they can’t readily escape. “It comes down to how you get your money out,” observed UBS’s Mora. In Latin America, for instance, only Brazil can offer investors strong liquidity, with Mexico a distant second. The strongest emerging markets tend to offer more enforceable laws than others, which translates into fewer headaches when it comes to executing transactions and exit strategies. Even in China, though, observed Bassini, it’s not easy to find the right investment vehicles and the right people with whom to invest.
The looming question is whether emerging market growth can be sustained in the face of slowing U.S. and Western European economies. Not surprisingly, panelist answers varied according to which emerging markets and what time frame.
The Latin economies have had the wind at their backs for the past four years, with low interest rates in the U.S. fueling demand for Latin labor, products and commodities. Wage growth among Latin immigrants has been second only to oil exports as a generator of growth. Yet the risks are large, observed Bassini, and fortunes could easily be reversed. If the U.S. economy turns downward, says Nicholson, the Latin economies, especially Mexico, will have difficulty avoiding recession. Even China’s economy, she thinks, could face problems once the boon from hosting next summer’s Olympic Games has passed.
Nevertheless, there are reasons to remain bullish about emerging markets — the BRICs in particular — no matter what may happen in the U.S. economy. At worst, speculated Fortress Investment’s Swati, China’s economic growth rate might decline from its current 11% to a still-torrid 8%. As for emerging market exports, the threat of a U.S. economic downturn will loom large over the next 8 to 12 months, but it will surely diminish over the next decade, as emerging markets develop stronger consumer economies of their own.
Knowing where to go next with investment capital is always a challenge. Nations go through changing cycles, Kaplan said, with each new developmental phase providing a new growth engine. Israel, for example, began as a largely agricultural economy in the 1940s and 1950s, before becoming a producer of industrial goods. More recently, its economic growth has been fueled by technology — a leap that countries like Singapore and Taiwan are now poised to make as well. Nations that can export valuable natural resources may be able to graduate from one developmental phase to the next with greater ease, Kaplan thinks, but all nations aspire to the same developmental trajectory, and they should be able to attract increased foreign investment capital as they progress.
Regardless how much of a near-term slowdown the world’s developed economies may be about to experience, the faster growing emerging markets seem likely to maintain momentum. Goldman Sachs forecasts that the BRIC economies will exceed the U.S. in consumer spending this year, with China leading the way. China’s average per capita income has now surpassed $7,000 and, as with per capita incomes in Russia, India and Brazil, the growth shows no signs of abating.
Meanwhile, the world’s economic balance of power has already begun to shift, as the oil-rich nations rake in ever larger quantities of wealth and the Asian central banks acquire enormous pools of capital — with growth in Asian pension funds and private investment vehicles sure to follow. “All this liquidity,” Leeds concluded, “will have to go somewhere.”