Will the Emerging Markets Emerge or Submerge?

An emerging economy, almost by definition, is an economy that requires significant foreign resources to carry on with its normal activities. Developed markets on the other hand, are thought to be nations which have a stable or high level of economic growth.  Developing markets used to be a puzzle to the international investing world, however this has now changed! The global economic system has now changed, with developing economies playing an increasingly important role.

Emerging economies have risen by almost 20% since the end of 2007, however the real GDP in most rich economies is currently still below its 2007 level. Issues within the developed economies have clearly caused the power shift. In 2010, the combined output of the emerging world made up 38% of the world GDP, almost twice its share in 1990. Emerging markets now make up for over half of the global consumption of most commodities, world exports, and inflows of foreign direct investment.

Though the emerging economies are far below their ratio compared to the developed world in commerce and finance, they seem to be fast catching up. In the last 2 decades, these economies accounted for 46% of world retails sales, 52% of all purchases of motor vehicles and 82% of mobile phone subscriptions.

In 1995, 4% of Fortune 500 firms came from the emerging markets, presently almost 25% of the Fortune 500 firms are dominated by companies from the emerging markets.

The question now is: will the emerging markets be able to sustain their growth with the developed economies facing crisis after crisis? As stated above, emerging markets require significant resources to keep going!

According to the Bank of International Settlements, the European banks are owed USD 3.4 trillion by the emerging markets and approximately 40% of this has been borrowed by Eastern Europe. With the European debt issues lingering, these banks are forced to meet higher capital ratio targets to save the Euro. Not wanting to raise equities which will dilute existing shareholders, they may choose to cut loans. This will directly limit credit supply to the emerging markets. Commerzbank, the second largest German bank, has stated it will suspend new lending outside its home country – wanting to support business at home – although Poland was made an exception as it has a subsidiary there.

Banks refusing to lend will affect the emerging markets that rely on foreign capital, as running out of foreign reserves makes it trickier to cut interest rates to stimulate the economy. Many emerging market currencies have seen a significant fall in recent months; this may be a sign of a “sudden stop” in capital inflows. A slowdown in capital private inflows into emerging markets may set off a sharp turnaround in an emerging market economy’s current account deficit. For an emerging economy running a current account surplus may not be a good indication of the economies long term growth prospects.

The last few years saw high levels of inflows from developed markets into the emerging markets due to low yields in home countries. However weakening currencies has now prompted investors to pull back as they may experience losses on investments.

Asia has still been considered a safer place than Eastern Europe, as they run a much lower current-account deficit, which makes them still attractive to big European lenders. However economies such as Turkey, which has a deficit of 10% of GDP this year, may be at risk.

China, an emerging market with the second largest economy in the world, has had three quarters of declining growth in a row; analysts believes that its growth could fall below 9% for the first time since 2001. However, in a recent closed door meeting, the Chinese policymakers have guaranteed that their growth will remain stable despite a gloomy global outlook. They have also assured that macroeconomic regulation policies and overall consumer prices will remain secure.

In November, several emerging economies lowered their growth forecast, with Thailand being the worst, following the most horrendous flooding it had experienced in decades. Thailand’s central bank was forced to cut its growth projection from 4.1% to 2.6% and warn of further downgrades. Third quarter GDP reports were rather flat, though Russia gained from strong domestic consumption.

As we have now seen major outflows due to a very risk averse period, equities within the emerging markets have taken significant hits. In the short term investors will continue to remain risk averse, however in a longer term horizon, we believe emerging markets have further headroom for growth. As we have seen in the past, investing in the emerging markets has been very profitable even in a short time frame. In 2009, the MSCI Emerging Market Index grew by over 81%, with India’s Sensex Index growing by 68%, China’s Hang Seng appreciating by 34% and Brazilian Bovespa index increasing by over 117%.