August 23, 2015    5 minute read

Understanding Emerging Markets

   August 23, 2015    5 minute read

Understanding Emerging Markets

Emerging markets (EMs) are usually defined as economies with low to middle per capita income – hence they are usually countries with low liquidity, in need of Foreign Direct Investment (FDI). That is, they need capital to be injected both in capital markets and in the real economy in order to add volume to the country’s stock/bond market and to long-term investments in infrastructure. Additionally, their economies are driven by the production of either commodities or manufactured goods. Therefore two forces drive the EMs economic cycle: global liquidity and demand for commodities, which depend mainly on two economies. The first depends on the conditions of the American economy, the latter on how China is doing, given that China is the biggest consumer of commodities. It has been fueling the commodities bubble through its growth at record rates. A bust, also due to China’s slowdown, has followed: as an example iron ore has slid 22%, and copper is down 19% by the beginning of 2015.

China, among other emerging countries like Turkey, Mexico, India, Thailand, Greece and Hong Kong, are exporters of manufactured goods. However a difference must be noticed: while the first three countries are running their economies with a positive surplus, the last three countries have to deal with a negative surplus. This means that they are hurt severely as soon as capitals start to flow out.

This is what has been happening over the past months. In particular, over the past 13 months $1tn has been flowing out, causing concerns about the fact that emerging economies can lead the global growth. The outwards flow will probably accelerate because of concerns about the instability of China and as soon as there will be signs of a rate hike in the US. This will cause liquidity-dependent economies to suffer, causing their currencies to weaken further. Morgan Stanley recently changed the “Fragile 5” ranking to “Troubled 10”. Ten nations suffered particularly after the Yuan’s devaluation since China was their top export destination: these include the Russian Ruble, the Thai Baht and the Brazilian Real, that has been the one losing the most against the USD since August 2013, the 35%, demonstrating how Emerging countries are very exposed to global risks.

The People’s Bank of China (PBoC) recently intervened in the FX market three times in a row by devaluing its currency, causing the Yuan (CNY) to decline by 4.65%. This has consequences on Treasuries, deflation and purchasing power. In particular the devaluation of the Yuan will cause Chinese families and firms to have weaker purchasing power. Additionally, commodities, whose price is generally denominated in US Dollars (USD), will be more expensive causing a stronger downward pressure on their prices and therefore on commodities exporters like Brazil, Argentina, Indonesia, United Arab Emirates, Kuwait and Qatar. Here too a difference has to be underlined: while the first three are running economies in deficit and the last three have a surplus. Countries like the first three are essentially exporting agricultural and mineral products, which prices have been falling in the past weeks. In particular the share price of many mining companies has collapsed. Their growth has been pushed by financing wide deficits that will deepen because of current global conditions: their economies will experience crises and, for example, deindustrialisation as seen in Brazil. The last three have economies essentially based on export of oil, but since they run surpluses they are less subject to the global liquidity cycle.

Overall imports from EMs in June, were 13% lower YoY, according to Capital Economics. This demonstrates how outwards liquidity flows and lower commodity prices have caused lower income in countries which economies are based on the export of commodities. In this moment investors are getting rid of EM currencies as faster as they can: think about the Turkish Lira (TRY), which dropped in the past days hitting a record low against the USD equal to 3$. As a result of the drops, JPMorgan’s EM Currency Index has declined by 2.4% this month, hitting its lowest since the 2000.

Why should investors put money in these countries given their instability? Emerging markets can be defined as assets tied to economies of risky countries. The appeal of the emerging markets is given by the fact of being risky – therefore investments in those countries have to embed a risk premium, very attractive in periods in which rates are very low. Risks can be given by geopolitical threats, impaired creditworthiness as reflected by speculative grades because of systematic defaults like in the case of Argentina and a non-democratic regime that might impede the creation of reliable capital markets based on contracts which are supported by a sound legal system. Another advantage is given by the diversification of a portfolio, allowing to eliminate or at least reduce the idiosyncratic risk. Therefore investments in emerging markets are attractive for their ability to diversify while adding risk to the portfolio.

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