23rd September 2010
Emerging Markets: The BRIC Economies & Beyond, by Cherry Reynard and Julian Marr, examines some of the ‘truisms' that have developed around emerging market investing. These are ideas that feel intuitive, but require further examination.
Consider the argument that the East is in the ascendancy while the West is in decline. Received wisdom now suggests the West is in permanent decline, while the East – particularly China – will be the future engine of world growth. The argument goes that Western economies have been left vulnerable by the freewheeling capitalism that once made them powerful. Their banks, citizens, corporations and governments are weighed down by debt and real economic growth is likely to become a distant memory.
In contrast, Eastern economies are in fine shape. Previous crises have ensured they have learned the lessons of excessive debt, their economies have recovered quickly, they have healthy current account surpluses with which to shore up their economies and their citizens are on the cusp of embracing consumer spending. The transfer of power looks assured – right?
There is plenty to support this argument. Western economies are now in the worst shape they have been in for many years. After hundreds of billions of dollars-worth of stimulus was injected to prevent a complete collapse in the banking system and to resurrect growth, Western economies finally began to expand again in the third quarter of 2009.
But even with the recession over, structural problems remain. UK public sector borrowing was set to be approximately £165m in 2010, according to the British Chambers of Commerce. Savings rates have been near zero, and consumer debt levels vast. Western economies are driven substantially by consumer spending, so the widespread deleveraging and higher taxes that are likely to characterise the fall-out from the crisis will impact them disproportionately.
What has prompted this weakness? Many economists would argue it is because every time a recession has loomed, central banks have slashed rates, thereby creating more debt and putting off the economic consequences. As this pain has been deferred, the difficult deleveraging process has been multiplied.
"Companies in the developed world could be facing permanent exclusion from emerging markets," says Chris Palmer at Gartmore. "During the global downturn, companies in the developed world fell behind in terms of launching new products into emerging markets. Meanwhile, in countries such as Brazil and China, local companies took market share."
Of course, Western companies still have financial firepower, so they may once more look to buy companies to gain a foothold in emerging markets. Ultimately, however, faith in Western institutions has been severely shaken. The central bankers look craven, governments look incompetent, citizens look greedy and companies look mismanaged.
In contrast, Asian countries – whether emerging economies such as Malaysia or the Philippines or more developed ones such as Singapore – appear to have learned their lessons from successive crises in the 1990s. They recognised their weakness lay in a lack of foreign reserves and grew their economies with a bias towards exports. They also recognised the problems of debt, particularly foreign denominated debt.
As such, the majority of Asian governments run with a current account surplus and large foreign exchange reserves. Estimates vary as to the extent of foreign exchange reserves, but most agree they were far better cushioned against any downturn than many developed economies. Russia, for example is thought to have around $400bn of reserves. It also has a $160bn sovereign wealth fund while, for its part, China launched the China Investment Corporation in 2008 with about $200bn.
The Asian banks largely sidestepped the credit crunch and remained well-capitalised and ready to lend as the economic environment improved. Furthermore, savings rates are high, GDP growth is robust and the lack of leverage means there is plenty of room for domestic consumption to grow.
The strength of the East has been in providing low-cost manufacturing (most obviously China), or services, (most obviously India), to which Western companies could outsource and these levers to growth are still largely in place. Equally, as China and India urbanise and industrialise, it creates demand for commodities, which in turn creates wealth for commodity-rich emerging markets such as Brazil and Russia.
This economic growth is trickling down to the citizens of all the BRIC countries, creating a nascent consumer economy that has built demand for consumer goods such as mobile phones, cars, white goods and clothing. Consumer growth is likely to be given a boost by strong demographics.
Growth is also likely to be generated by infrastructure development. The Indian government, for example, has earmarked $400bn to $450bn for infrastructure development, which will include power, ports, roads and telecoms, and China, Russia and Brazil are planning similarly ambitious infrastructure projects.
In examining whether the decline of the West and the rise of the East are likely to become a permanent economic reality, it is necessary to judge whether all these factors are likely to remain in place. Emerging markets are not without their problems. Political instability remains a risk and, while many emerging markets have had stable regimes in place for some time, history suggests things can change very quickly. For example, Venezuela in the 1970s looked as if it would be one of the emerging market success stories on the back of abundant oil reserves, but unhelpful politics has meant it has failed to develop.
Furthermore, while corporate governance in the West has been shown to be flawed and Asian corporate governance has improved, some emerging markets still have weak shareholder protection and a marked lack of transparency – with the Russian market in particular dogged by these issues.
Equally, the West may not prove to be as weak as some commentators expect. The US economy has shown itself to be resilient over time – not least because its labour laws are flexible and it is easy to set up businesses there. Education and training are strong and the West is still home to world-class companies.
The shift in economic power from West to East is real and tangible and harnessing this trend is important for long-term investment. The West may well rise again from this gloom, but it has a battle ahead to retain its economic supremacy.
The above is an edited extract from Investing in emerging markets – the Bric economies and beyond, which is written by Julian Marr and Cherry Reynard and published by John Wiley and Sons in association with the Chartered Institute for Securities & Investment.