Treasury Today Country Profiles in association with Citi

Emerging market risk

Baby crocodile hatching from egg

Despite the fact that emerging markets now make up more than half of global GDP, many investors are still in the dark about the risks and opportunities they present. We spoke to a range of experts to find out what emerging markets are, the special challenges they pose, and their outlook for the future.

Investing in emerging markets (EMs) can be something of an acquired taste. Even while investors struggle to achieve a decent yield in developed markets, some still balk at the high risk they perceive to be inherent in EMs. Recent performance of EM stocks has done little to inspire investor confidence.

Indeed, EMs underwent a torrid end to the third quarter of 2014. In September, the FTSE Emerging Index, comprised of large- and mid-cap securities from advanced and secondary EMs, declined for seven days in a row, dropping almost 3% for the week. This was both the longest run of falls – as well as the largest weekly decline – since November of the previous year.

Increasing Treasury yields have historically harmed developing markets, and talk of the Fed potentially raising its benchmark interest rate has had this exact effect. “EM assets have again come under pressure as fears of higher US rates and a stronger dollar have outweighed the promise of additional liquidity from the ECB,” wrote Robert Burgess, Chief Economist at Deutsche Bank, in a research note published in September.

However, as has been widely reported by the financial press, some EMs’ current and prospective growth dwarfs that of many developed markets. For instance, both India and China have exceeded GDP growth in the US by at least 1.5% every year since 2001. What exactly are EMs, and what are the risks investors need to understand before venturing beyond developed markets?

Defining emerging markets

One challenge with emerging markets is actually defining what they are. The term itself is not particularly helpful. Considering that EMs now make up more than half of the world’s GDP according to the International Monetary Fund (IMF), the word ‘emerging’ appears to be something of a misnomer. Many of these markets have very much emerged already.

While it is reasonably safe to assert that some economies, such as the US, are developed, and others, such as Chile, are emerging, the exact measure of why some are EMs and others are not can be ambiguous. And many countries qualify as EMs according to some criteria but not others.

“There is no hard and fast rule for defining EMs – it’s an amalgam of lots of different things,” says Timothy Ash, Head of EM Strategy, Ex Africa at Standard Bank. “You can look at per capita GDP, but it is more subjective than that. There are also factors such as institutional capacity and strength, business environment, rule of law, legal system, and political stability. Some countries are clearly emerging markets, while others are borderline, and on top of this the parameters are constantly shifting.”

The Czech Republic, for example, makes it onto the FTSE Emerging Index (as one of its ‘advanced EMs’), but it does not qualify as one of the IMF’s ‘emerging economies’. Conversely, the IMF considers Estonia an EM, although the Baltic republic does not feature on the FTSE’s Index.

Another EM yardstick is the G10 currencies. The 11 economies that make up the confusingly named Group of Ten (comprising Belgium, Canada, France, Italy, Japan, the Netherlands, the UK, the US, Germany and Sweden, as well as the 11th member, Switzerland, which joined later) are widely considered to be developed by most measures. Some investors and economists consider that anything beyond G10 could reasonably be an EM, although opponents claim it is an overly broad definition.

While there is some ambiguity as to what an EM is, there is more consensus around the benefits they present investors. The biggest of these is pure and simple yield.

Chasing yield

“Yield is a big selling point for EMs, as there is really no yield left anywhere else,” Benoit Anne, Head of EM strategy at Societe Generale tells Treasury Today. “Quantitative easing policies undertaken by the Fed and other big central banks in developed economies have pushed rates to record lows for quite a few years now. This has driven a strong appetite for EMs among investors.”

Despite the attractiveness of EM yields, the markets are not immune to turbulence. The MSCI Emerging Markets Index hit 1,083 at the beginning of 2013, before falling to as low as 883 in June of that year – a fall of almost 20% (see Chart 1). Only in Q3 2014 has it started to reach the heights of January of the previous year.

Chart 1: MSCI Emerging Markets Index performance
Chart 1: MSCI Emerging Markets Index performance

Source: MSCI

“Of course last year there was a massive correction in EMs, simply because markets sometimes need to correct themselves when they become over popular and overpopulated,” adds Societe Generale’s Anne. “But overall EMs still offer a favourable environment. The European Central Bank’s recent big policy signal (to cut interest rates to a record low and to buy up private sector bonds, in September) is promoting this environment, and until the Fed starts hiking its rate, EMs will continue to be well positioned.”

This favourable environment for investment has been facilitated by economic, infrastructural, and political advances in many of the larger EMs.

“EMs have undergone a tremendous change with respect to the economic fundamentals over the past ten to 15 years,” says Maria Laura Lanzeni, Head of Emerging Markets Sovereign Risk at Deutsche Bank Research. “There is a very long-term structural trend in many of these markets towards better management of external debt, reduced exposure to dollarised debt and dollarised banking sectors, increased fiscal prudence as well as more central bank independence and anti-inflationary policies. These trends are obviously not present in all EMs, but overall the average EM is much better placed from an investment and risk perspective than in the 1990s.”

Furthermore, this contrasts with conditions in certain developed markets, which in recent years have not progressed in this respect, and have indeed in some ways regressed. A number of large developed markets have gone backwards, especially in terms of their fiscal accounts and public debt, including the Eurozone, Japan and the US. Given the very serious fiscal problems the governments of these developed nations are grappling with at the moment, EMs can therefore look relatively attractive to investors.

Standard Bank’s Ash concurs that recent events have made the case for EM investment somewhat more attractive in relative terms. “Some EMs are arguably less risky than some developed markets these days,” he argues. “Particularly in the case of sovereign debt, the European periphery crisis has proven that many developed markets are perhaps not what you think they are, and that perhaps the ability and willingness to pay off sovereigns in some EMs are better.”

He cites Poland as an example of this. Though an EM according to many measures, its balance sheet and willingness to pay off sovereign debt is superior to many Eurozone periphery countries, he says.

First world problems

Beyond the yield benefits, diversification is another factor drawing many investors to EMs. “There is a structural drive among the investor base to allocate more of their assets to EMs simply to reflect these markets’ greater share of global GDP,” explains Standard Bank’s Ash. “Especially from a fixed income perspective, investment funds’ investment mixes are still generally underweighted in their exposure to EMs.”

However, as they compete with developed markets for investment, EMs have also started to experience some of the ‘first-world problems’ their more developed counterparts are used to. Rapid growth must also be handled sensibly and sustainably, otherwise it may be short lived.

Brazil, for example, once the darling of many EM investors and part of the BRIC group (also comprising Russia, India and China), has struggled of late. Partly on the back of foreign direct investment, its GDP rocketed from $504 billion in 2002 to a whopping $2.5 trillion in 2011 – almost a five-fold increase. In 2012 its GDP decreased to $2.25 trillion, and in September 2014 economists reduced their forecasts for the country’s expansion – the 15th downgrade in Brazil’s growth outlook so far in 2014. Brazil, which is the largest economy in Latin America, fell into technical recession in Q1 2014.

“As EMs come into the mainstream, they also become subject to the same trends and fluctuations in their business cycle that affect more developed economies” says Deutsche Bank’s Lanzeni. “Much of the euphoria that surrounded Brazil five years ago was perhaps premature, as lots of money flowed into the country, but reforms then started to falter, with obvious repercussions for the country’s growth. As economies grow, so too does the extent to which they are subject to global economic conditions at large.”

Currency restrictions

One key challenge to investing in EMs is the currency restrictions in place in certain jurisdictions.

“Currency controls and direct intervention in FX markets are key factors impacting both equity and fixed income investments in EMs,” says Societe Generale’s Anne. “The exchange rate policy a government pursues also needs to be considered before you invest there.”

The difficulty for those looking to invest in these markets is that these controls are often subject to rapid change. However, this change can also work to the advantage of investors. China is a prime example of an EM where rapid regulatory change is benefitting foreign investors.

“The possibilities from a currency standpoint in China today are significantly greater than they were two or three years ago. While a full-scale hedging programme for RMB risk is still not as easy as it is for euro-dollar risk, it is now feasible at least,” says Kevin Lester, Co-CEO at Validus Risk Management. “A fast-changing regulatory background is one of the defining features of EMs. It is important that treasurers take this into account when drawing up a risk management programme for EM investment, and that they remain adaptive and open to rapid developments.”

In addition to tighter currency restrictions, another argument sometimes made against EM investment is that many less-developed jurisdictions are rife with corruption. Obviously generalisations like this are of extremely limited value.

The Corruption Perceptions Index, published by NGO Transparency International, is a ranking of 177 countries and territories based on how corrupt their public sector is perceived to be. Countries are scored from 0 (highly corrupt) to 100 (very clean). In the most recent Index published in 2013, two-thirds of countries scored below 50, with none scoring the top 100 score and none the minimum 0.

Denmark and New Zealand topped the index with scores of 91, with Finland and Sweden in joint third (with a score of 89) and Norway and Singapore joint fifth (with 86). The most highly corrupt countries, according to the index, are Afghanistan, North Korea and Somalia (joint 175th place, with a score of 8).

The Index suggests that EMs do tend to be more corrupt on average than developed countries. There are, however, some notable exceptions. Italy, a developed economy by most measures, comes in joint 69th place (tied with Kuwait and Romania on 43 points). Barbados, meanwhile, is ranked joint 15th(tied with Belgium and Hong Kong on 75 points), while Chile and Saint Lucia come in at joint 22nd(tied with France with a score of 71).

Of the BRIC nations, Brazil is the highest ranked, in joint 72nd place (tied with Bosnia and Herzegovina, Sao Tome and Principe, Serbia and South Africa, with 42 points). Russia is the lowest-ranked of the ‘big four’, ranked joint 127th place (tied with Azerbaijan, Comoros, Gambia, Lebanon, Madagascar, Mali, Nicaragua and Pakistan with a score of 28). China comes in at joint 80th place (tied with Greece on 40 points), while India is ranked joint 94th(tied with Algeria, Armenia, Benin, Colombia, Djibouti, the Philippines and Suriname on 36 points).

Standard Bank’s Ash points out that the problem of corruption is not limited to EMs. “Corruption is everywhere, and we have seen high-profile corruption cases in developed markets. Clearly, high levels of corruption stall economic growth, slow investment, and make the business environment more challenging,” he says.

Deutsche Bank’s Lanzeni concurs that there are a number of examples of corrupt jurisdictions in developed markets and ‘cleaner’ EMs. “Long-term corruption has a negative impact on a country’s growth prospects, and while this remains a problem in many emerging economies, there are examples of ‘islands of cleanliness’, such as Uruguay and Chile in Latin America, and Botswana in Africa – that is, economies in a region not characterised by above-average governance but which have themselves managed to stay relatively clean.”

Geopolitical risk

Perhaps even more than corruption, geopolitical risk is a key consideration in investing in EMs.

“With multiple confrontations and conflicts taking place at any one time, the geopolitical context is a crucial risk point in weighing up EM investment decisions,” says Lanzeni. “While you may be able to know where there are tensions and unrest and analyse the environment that could lead to conflict, you cannot really predict exactly when something will erupt. The fact that the Arab Spring came as such a surprise to most if not all analysts, is proof of this.”

Despite this apparent difficulty in predicting when conflict situations might flare up, there are ways of assessing which countries are most at risk. Risk consultancy Maplecroft publishes an annual ‘Political Risk Atlas’, ranking countries in terms of the risk and placing them into five categories: extreme risk, high risk, medium risk, low risk, and no data. In its 2014 Atlas, Somalia was ranked the country with the highest political risk, followed by Syria, Afghanistan, Congo, Sudan, Central African Republic, Yemen, Libya, South Sudan and Iraq. All these countries were categorised as at extreme political risk.

In the study, Maplecroft said that since 2010, almost 10% of countries worldwide have seen a significant increase in the level of dynamic political risk, “with foreign investors facing increased risks of political violence, resource nationalism and expropriation.”

Beyond potential conflict situations, political events can influence the business environment in a country too. The Brazilian general election set for October 2014 is one key date that EM watchers will follow with interest.

Similarly, Argentina has been under the spotlight of late since the country’s debt default in July. The economy is not currently an attractive market for foreign investors, with the central bank’s foreign currency reserves at their lowest level for eight years, and inflation bordering on 40%.

“The situation in Argentina illustrates the political risk dimension that investors in EMs can be exposed to,” says Validus’ Lester. “Not only is the currency risk very significant, but the fact that an entire company can be seized from an investor without warning is even more of a danger.”

In the short to medium term, it seems the recent rocky patch EMs have experienced, with investors taking capital out to move to developed markets (particularly the US), will continue amid speculation that the Fed could bump up interest rates before long. One defining risk of EMs is that they can be much more prone to swings based purely on market confidence than more developed markets.

However, despite the risks, as long as interest rates in developed economies remain low, and provided that the BRIC countries, particularly Brazil, can get back on track, investors may well see EMs as an asset class to keep an eye on.