Submerging markets

Feb 22, 2014

The US seeking a higher return. While capital flowing into economies is usually considered a good thing it is in many way damaging for emerging economies. The principal problem is the sheer scale of the sums when the wave arrives. Local assets rise in price as does the currency making the economy less competitive. It also destabilises local capital markets and undermines their growth and maturity. They are unable to process or compete with the flows and find themselves forced out of participating in their own market just as it booms.

Emerging markets have endured a weak start to 2014 and further sharp losses after the devaluation, but they should not be viewed through the prism of the last crisis in 1997-8. In this “Asian crisis” a local issue in Thailand escalated into a full blown currency collapse as investors simultaneously fled. Central banks had limited foreign currency reserves and as their ability to service their US$ debts diminished so the panic rose.The tapering of quantitative easing in the US has led to a decline in the price of US bonds and an increase in their attractiveness. The money has started to flow home. So far in 2014 the South African rand, Turkish lira and Brazilian real have all declined about 5% relative to the US dollar. By the end of January Argentina had fritted away 10% of its foreign currency reserves defending the peso but eventually recognised the inevitable and withdrew any further support. After a sharp fall the peso has stabilised at around 20% lower level (v US$) than at the start of the year.

Emerging markets suffered acute pain and such lessons are not quickly forgotten. Over the last fifteen years foreign currency reserves have been steadily accumulated ($7.7tn according to the Economist Feb 2014), exchange rates, if not wholly free from government intervention, are significantly freer. As a whole emerging market economies are well managed. Few run a current account deficit above 5%, and debts are usually held in local currencies which diminishes the consequences of currency devaluations. Inflation is mostly under control and interest rates are used, at times aggressively, to cool overeating economies. While they are by no means flawless (inflation data is at times manipulated, corruption is slow to diminish and politicians complacent) as a whole emerging market economic governance has been clearly competent.

Unfortunately, in the short term, the sheer weight of American money returning home will disrupt economies and currencies and will lead to falls in asset prices. For the short term there is little to recommend investing. Longer term the attractions are obvious. The major economic influence on world growth since the millennium has been the emergence of China into the market economy. The application of western innovations to capital and a workforce emerging from subsistence farming has transformed the lives of hundreds of millions of Chinese people. This process is getting stale in China but will be replicated in other populous nations. Brazil and sub-Saharan Africa have made headway already and Indonesia, Pakistan, Nigeria and Bangladesh amongst others could find their economies transformed in the coming decades.

For the time being we will watch the coming disruption from the sidelines, but our intrinsic optimism for emerging markets suggests we will be looking to allocate increasing amounts of capital to these markets when the valuations have become sufficiently attractive to overwhelm the risks, however this appears unlikely in the short term.

Argentina’s decline has been seductively gradual. Throughout its decline, the cafés of Buenos Aires have continued to serve espressos and medialunas. That makes its disease especially dangerous.

In the emerging world, where uninterrupted progress to prosperity is beginning to be seen as unstoppable, too many countries have surged forward on commodity exports, but neglected their institutions. With China less hungry for raw materials, their weaknesses could be exposed just as Argentina’s was. Populism stalks many emerging countries: constitutions are being stretched. Overreliant on oil and gas, ruled by kleptocrats and equipped with a dangerously high self-regard, Russia ticks many boxes. But even Brazil has flirted with economic nationalism, while, in Turkey, the autocratic Recep Tayyip Erdogan is blending Evita with Islam. In too many parts of emerging Asia, including China and India, crony capitalism remains the order of the day. Inequality is feeding the same anger that produced the Peróns.

The lesson from the parable of Argentina is that good government matters. Perhaps it has been learned. But the chances are that in 100 years’ time the world will look back at another Argentina—a country of the future that got stuck in the past.”