Always Emerging

(I write a monthly column for a Chinese newspaper.  Here is the draft of this month's column)

There are 195 sovereign states, according to the United Nations, and two “observer states” (Vatican and Palestine).   The high income countries in North America, Western Europe and Asia-Pacific account for about 15% of the sovereign states.  Most of the rest of the world live in low and medium income countries.  

During the Cold War, low-income countries were often called Third World.  Later the jargon changed to Lesser Developed Countries (LDCs).  More recently, they are referred to as emerging markets (EM) or emerging market economies.    There are around two dozen emerging market countries that have been integrated into the global economy and capital markets in a significant way.  Of these, population and economic capacity is concentrated in half a dozen countries.  Even though Albert Edwards rightfully has called BRIC, "a bloody ridiculous investment concept," it does underscore the concentration in the EM space.  

Moreover, it has proven difficult, though not impossible, to pass from the emerging market status to developed status.     The United States itself began off as colonies of one of the strongest empires of the time.  In 1880, the US and Argentina were roughly of similar economic  development.  In the 1950s and 1960s, Japan developed the modern export-oriented strategy, and succeeded in moving up the value-added chain quickly.  It proved to be a model that other countries have replicated.  

However, the experience of many of the emerging market countries that have prospered is difficult to replicate.  Consider that many successful emerging market economies in Asia were British colonies.  Others, like South Korea and Taiwan, were aided by a super-power rivalry.   The international environment has also dramatically been altered by the integration of China, a low-cost, large-scale producer.   

Since the 1970s, banks and international investors became enamoured with investing in the low income economies several times.  It often ended in tears.  There is a recurring behavioral pattern.  The investors see under-valued assets.  Lenders see worthy credit risks.  Rising asset prices, and the improving liquidity attracts other market participants.  Leverage grows.   Narratives are constructed.  Reforms are emphasized.  Leverage grows.  

Then the macro economic situation changes.  Assets are not so cheap.  Debt levels are elevated.  Terms of trade may change.   A bear markets follows a bull market as night follows day.  The leverage, coupled with the lack of transparency, inflicts pain on lenders and investors.  

The behavior of low income countries has also been repeated through several cycles.   High domestic rates encourage borrowing in foreign currencies, especially the dollar.  This works for a while, until it doesn’t.  Often a tightening cycle by the Federal Reserve exposes the vulnerability of such currency mismatches. 

We are in the downside of the cycle now.  There were five forces that drove the cycle and each has weakened. 

First, the dollar was weak from 2000 through 2011, when the real broad trade-weighted index set a record low.  Now it is strong.  It has been trending higher since mid-2014.  Second, the Fed’s balance sheet swelled form around $900 bln to over $4 trillion.  Now the Federal Reserve has signaled first the end of its unorthodox monetary policy, and continues to warn that it is likely to raise interest rates in the coming months.  

Third commodity prices were rising in absolute terms and relative to manufactured goods prices.  Many low income economies are export commodities and import manufactured goods.  This was a positive terms of trade shock.  This has reversed dramatically over the past 12-18 months.  Fourth, world growth was strong.  Many benefited from the rising tide.  World growth has slowed dramatically.   The cross border movement of goods, services, and capital are well off their pre-crisis high. 

Fifth, and linked to some of the other forces, has been the slowing of China, the world’s second largest country.  It appeared that the price of various commodities, from iron ore to soybeans, from pork to steel, were set by China’s voracious appetite.  Sometimes it appeared that part of the demand for commodities was more about collateral to secure loans than production itself.  

While history, said the American humorist Mark Twain, may not repeat itself, it often rhymes.   There are several factors that make this downside of the cycle unique.  Perhaps the most important of these is that the countries under the most pressure do not have fixed exchange rate regimes.  When they break, it is often ruinous in the first instance for the low income country and for investors.   It is almost like a dam bursting.  This is what happened, for example, in the Asia in 1997-1998.  

One of the lessons many countries drew from that experience was to amass a stock of foreign currencies.  The accumulated reserves can act as a form of self-insurance.  Countries can build a cushion so when the hot money flows out, they have the ability to moderate it. 

Having a large war chest of reserves does not immunize low income countries from the vagaries of the capital markets.  However, the reserves could ameliorate some of the hardship and facilitate a quicker recovery.  

There are now a large number of sophisticated investors who embrace the emerging markets as an asset class.  They are dedicated to it.  In addition, for many investors, emerging market exposure is an integral part of a diversified portfolio.  There are also a number of world-class companies that are based in the lower income countries, and this keeps investors committed.  

In the downside of the cycle, the prices of emerging market assets and currencies tend to overshoot measures of fair value.  The down cycle lasts longer and is deeper than many investors anticipate a priori.  The assets get sufficiently cheap that the groundwork for the next upswing is laid.  

Patience, discipline and value are the watchwords. 

disclaimer