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July 11th 2009

Investors Disagree over Emerging Markets

Since touching a low in March, the emerging market class has risen by 50%, according to one measure. This led to concerns that another bubble was forming, a swift pullback ensued. The bulls, however, point out that valuations remain well below 2007-2008 bubble levels and that according to some measures, fundamentals are actually quite strong.


They have a point. With the exception of a few bailouts in Eastern Europe, emerging markets as a whole have actually weathered the storm quite well. As one analyst points out, “Governance has improved, many countries run current-account surpluses, foreign-currency reserves have grown, the middle classes are expanding and savings rates are high. Countries such as Brazil and Turkey have been able to cut rates during the crisis and still attract money.”

In fact, it wasn’t even until the collapse of Lehman Brothers in September 2008 (when some might say the credit crisis entered the worst stage) that investors even began to pull money from emerging markets. “During the first half of 2008, gross capital inflows to EMEs held up remarkably well, in many cases reaching 60–70% of the record high inflows in 2007…The fact that other investors (banks and bondholders) maintained their positions in EMEs may be attributed to a number of factors…including much larger official foreign exchange reserves and more robust banking systems in many cases.”

Accordingly, it could be argued that the recent rally in emerging markets could represent a “reverse correction”- an acknowledgment that the record decline was simply an overreaction. While stocks still remain well below their record highs, bonds are rapidly approaching pre-crisis levels. The spread between the JP Morgan EMBI+ index and US Treasury securities is now approximately where it was one year ago.
The naysayers, though, like to remind people that emerging markets are inherently risky: “The past decade or so alone has seen the Asian crisis, the Russian default and another round of restructuring in Latin America. Populist politics, poor fiscal management, a reliance on foreign-currency borrowing and fixed exchange rates were a magnet for trouble.”

Sound macroeconomic and fiscal policy notwithstanding, it’s clear that certain structural problems remain extant: “In February 2009 it became clear that the state of these economies was deteriorating faster than expected. Many borrowers faced challenges repaying or rolling over their loans. The loss of investor confidence suddenly exposed long-standing vulnerabilities, such as the widespread practice of foreign currency borrowing by households and by small and medium-sized enterprises.” In addition, emerging markets collectively remain heavily reliant on exports to drive growth, which is problematic given that, “The synchronised fall in exports intensified in the first quarter of 2009 with an average year-on-year decrease of around 25% in a set of larger EMEs. In some commodity-exporting countries, notably Chile and Russia, exports fell by more than 40% in the first quarter of 2009.”

The best way to account for this schism between capital inflows and economic uncertainty is a shift in the way emerging market investors view risk. Previously, it was default risk that predominated. Now, however, it is inflation and currency risk, as well as corporate credit risk, that guides investor thinking.

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Posted by Adam Kritzer | in Emerging Currencies, News | No Comments »

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