Emerging Markets: Risks, challenges and opportunities
06 Jan 2012
Over the past 10 years, emerging markets (EMs) have become an increasingly important focus for many investors, as fundamentals have improved markedly – public debt/GDP in EMs is now lower than in developed markets (DMs), fiscal balances are positive in many more EM countries than DM, the political and investment climates in EMs are much healthier than before.
These have contributed to ratings upgrades of the EM countries, while at the same time, many DM countries were downgraded. Furthermore, EMs have been the main driver of global growth in recent years, and are expected to remain so over the next decade. Indeed, back in April 2011, the IMF forecasted that China’s economy would surpass US in purchasing-power-parity (PPP) terms by 2016.
As we enter 2012, the global outlook is more uncertain than at any time since the 2008 global financial crisis. The Eurozone sovereign debt crisis shows little signs of any enduring resolution, and is one of the reasons why the Euro area is expected to fall into a recession next year. The fiscal drag from the US deficit reduction is likely to result in sub-par growth in the world’s largest economy. As DMs remain in the doldrums, there are increased risks and challenges in investing in EMs, as the latter are unlikely to decouple from the rest of the world. Indeed the IMF forecasted (as of September 2011) EM real GDP growth to decline from 6.4% in 2011 to 6.1% in 2012, and further downward revisions look likely, especially as the Eurozone debt crisis lingers on.
However, it is worth highlighting that EM growth is still expected to outperform DM growth: DMs are forecasted to grow at an aggregate level of 1.9% in 2012. Further downward revisions are likely – the latest growth forecast by OECD released in November sees Euro area growth at just 0.2% in 2012, much lower than 2% in the US. Despite the potential growth downgrades, the growth differential between EMs and DMs is expected to remain at around 4-5 percentage points, similar to 2010-2011.
Exhibit 1: EM is still expected to drive global growth in 2012
Source: IMF World Economic Outlook (September 2011)
On the risk side, the focus over coming months will be the Euro area sovereign debt crisis. There are several ways in which EMs can be impacted, with the Central and Eastern European, Middle East and Africa (CEEMEA) region likely to be the worst hit. Firstly, there is contagion via financial channels: asset disposals and withdrawal of funding. European banks are likely to reduce EM assets as they deleverage, in order to meet their domestic regulators’ higher capital requirements. If these assets are sold to another foreign buyer, capital outflows from these EM countries will occur, thus weakening the currencies and balance of payment dynamics of these countries. Due to their physical proximity, many banks in Central and Eastern Europe (CEE) have European banks as their largest shareholders, and are therefore most vulnerable to asset disposals by European banks. Austrian banks, which have expanded extensively into CEE, may be at the forefront of divestments. Russia, Turkey and South Africa, which have comparatively closed banking systems, should be less at risk. Outside of CEEMEA, European banks also have controlling stakes in the Mexican and Chilean banking sectors, but are less involved in Asia.
Withdrawal of funding is the other financial channel where DM to EM contagion could occur. European banks may decide to repatriate some of the funding provided to EM banks, in the event that the former faces large losses at home. According to Morgan Stanley estimates, around EUR 1.7 trillion of total European bank debt will mature over the next three years. Recent rises in bond yields and increased risk aversion among investors present a much more difficult environment for European banks to raise fresh capital or roll over existing debt. Besides disposing of non-core assets as discussed above, European banks are expected to reduce lending and funding to their EM subsidiaries. European bank lending to EMs fell by 20% during the global financial crisis in 2008/09 (Source: Morgan Stanley), and could fall by even more this time around, as some of these European banks undergo a more aggressive deleveraging exercise. The impact is two-fold: not only will capital flow out of EMs, domestic lending activities in these EM countries are likely to slow further, resulting in a protracted period of sub-par growth. Again, the most vulnerable countries to funding market risk are those in the CEEMEA region, followed by Latin America (especially Chile, Argentina and Colombia). Emerging Asian countries, particularly China, Malaysia and the Philippines, are expected to be the least affected via this contagion channel.
Exhibit 2: European banks have to roll EUR 1.7 trillion of term debt over 2012-14
Source: Bloomberg, SNL, Factset, Morgan Stanley estimates
Besides the financial channel, the second means of contagion from DMs to EMs is via the trade channel. The Eurozone debt crisis, as well as sub-par US growth in 2012, is expected to drag global growth lower. The most salient trade link is via exports from EMs to Europe, as well as to the rest of the DMs, particularly the US. Due to its heavy concentration in commodity (hydrocarbon) exports, Russia is most exposed to a drop in European demand. Turkey is also vulnerable but its exposure to the US is very low. China and Korea also stand out for their shares of exports going to Europe and the US combined – nearly 9% of GDP in each case, according to estimates by Goldman Sachs and the IMF. While Mexico has the lowest exposure to Europe, it appears very vulnerable to a slowdown in US demand, with exports to US accounting for nearly 25% of its GDP. Less globalised states, such as Indonesia, India and Brazil should be impacted the least, although commodity exporters like Brazil tend to be more vulnerable during the downturn.
China’s growth slowdown is another risk to EMs in general, and to Asia in particular. In its latest update in November, the World Bank projects 7.8% GDP growth in the Emerging Asian economies in 2012, outperforming other regions. This is on the back of their forecast for China to grow at 8.4% in 2012, compared with 9.1% in 2011. However, growth risks are skewed to the downside, with exports and domestic housing construction slowdown being the two largest threats for China. Fears of a “hard-landing” in China were present for much of 2011, with whispers of 6% GDP growth or even lower not uncommon. Along with the DM growth slowdown, a significant and abrupt deceleration in China’s growth could have strong repercussions for global commodity producers. EMs will be one of the main casualties, given the heavy exposure to commodity prices of Latin America, the Middle East and Africa. As intra-regional trade relationship is tightest between China and Emerging Asia, the latter is likely to experience a fall in exports much more strongly and quickly than any other regions around the world.
To be sure, while an increase in Chinese consumption may help engineer at soft landing for the domestic economy, it is unlikely to save the rest of the world. In 2009, while the world slowly recovered from the recession, the Chinese economy grew the fastest of any major economy at 8.7% of GDP. This was thanks to the Chinese government’s record RMB 4 trillion fiscal stimulus package, which was focused on infrastructure and social welfare. These measures helped boost both the domestic and world economies, particularly in the construction, mining and retail sectors. Looking forward, however, given the higher public debt/GDP and credit outstanding/GDP within China, as well as concerns for the property sector, off-balance sheet lending and small-and-micro enterprises (SMEs), any future stimulus is unlikely to match the magnitude of that in 2009.
Despite the various risks outlined above, the outlook for EMs should remain positive over the next decade, especially compared to that of DMs. Better fundamentals and low financing needs provide EM countries more policy flexibility than DM countries when it comes to stimulating growth. While DM countries are running low on stimulus options, EM policymakers have more scope to ease policy rates since average EM inflation now is lower than in 2008, and the headline inflation decline has further to run (5.9% year-on-year currently vs. 7.8% when Lehman Brothers collapsed). Furthermore, many EM countries have raised policy rates since 2010 as the market recovered, and can therefore afford to ease more aggressively as growth slows down next year. This is particularly true for Latin America, where the central banks had hiked policy rates by 230 basis points (bp) (in GDP-weighted average terms) since their prior trough, surpassing the tightening in CEEMEA (36bp) and EM Asia (167bp). Moreover, EM foreign exchange reserves, totaling USD 6.4 trillion, are now USD 2.2 trillion higher than 2008 levels, thus providing EM countries room to maneuver and manage any significant foreign exchange volatility. Given the risk factors outlined above, we find Asia and Latin America fundamentally more sound than CEEMEA, from a top-down perspective, as shown in our proprietary EM scorecard.
Exhibit 3: EM Scorecard – Asia and Latin America are ranked higher than CEEMEA
Source: CIO Office, J.P. Morgan
Fiscal health in EM countries is also in much better shape than DM countries, allowing fiscal stimulus to be more forthcoming in EM. According to J.P. Morgan’s estimates, average public debt/GDP for EM countries stands at 34%, with only two investment grade EM countries – Hungary and India – having a public sector debt/GDP ratio of over 70%. Only two investment grade EM countries – India and Malaysia – run a fiscal deficit over 4% of GDP. On the contrary, the US and most Western European countries have seen their fiscal balances moving further into deficit, with some in double digits as a percent of GDP. Moreover, these DM countries have high (and rising) public debt/GDP ratio – over 100% in Greece, Italy, Ireland and Portugal.
Most EM countries also have younger populations and are therefore likely to sustain higher growth rates over the next decade, as the economy becomes more focused on domestic consumption, and less on trade. This also means that these EM countries’ ability to repay their debt obligations is higher and more sustainable compared to DM.
Exhibit 4: Deteriorating debt metrics in DM…
Gross public debt as % of GDP
Source: IMF, EC, J.P. Morgan
Exhibit 5: …compared to average debt/GDP of 34% in EMs
Source: J.P. Morgan
The achievements of these EM countries can be seen clearly in the rating actions. Given the positive developments above, many EM countries have been upgraded in recent years, while many DM countries have been downgraded. Since 2008, DM countries have experienced 68 downgrades, while a total of 47 EM countries have experienced 117 upgrades. So far in 2011, EM countries have experienced 35 upgrades, compared to 32 downgrades and no upgrades for DM sovereigns. The convergence of EM ratings to that of DMs is likely to continue, as a total of nine DM countries remain on negative outlook or review for possible downgrade.
Exhibit 6: DM country ratings have experienced 68 downgrades since 2008, while EM countries enjoyed 117 upgrades
Source: S&P, Moody's, Fitch, and J.P. Morgan
To conclude, the troubles in DMs will inevitably introduce a more challenging investment environment in EMs in the shorter term, given the close financial and trade linkages. Recent data points to weaker domestic demand in both EMs and DMs, and early indications that trade with DMs is turning toward a material drag. However, over the longer term, EM growth is still likely to outperform DM, and fiscal dynamics in EMs are expected to remain healthier. There are also more policy bullets for EM policymakers to stimulate their economies, both from a monetary and fiscal standpoint. Coupled with the younger, more favorable demographics, EMs are expected to remain as the main driver of global growth, capable of offering a plethora of investment opportunities in the years to come.
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