Emerging Markets Weekly

China's economy is starting to run hot again thanks to a significant fiscal and monetary boost over the past six months. Lending jumped by roughly 30% in March and April, a total of US$758-billion in new bank lending in the first four months of the year.

The positive implication of the loan expansion is economic recovery. Steel production ramped up in earnest at the end of the 2008, rising by 24% since late December. The retail autos sector has also rebounded -- nearly doubling in monthly sales volume since last summer.In fact, China is experiencing a broad-based economic recovery with the exception of the export sector. The manufacturing purchasing manager's index fell off a cliff late last year with the collapse in exports but now points to economic expansion.

Investors concerned that the major rise in lending could lead to a banking crisis are misplaced however. The banking sector was very well capitalized heading into the current downturn according to Peter Bottelier, Senior Adjunct Professor of China Studies at John Hopkins Univeristy in a recent conversation; non-performing loans will obviously rise says Bottelier but will not lead to a US style banking problem. For one thing, the consequences of this rampant loan growth are potentially more benign for China than for the developed world because private sector credit penetration is obviously far lower in China.

Moreover, China has already undergone effective bank recapitalization this past decade in China as a result of bad loans to unproductive state owned enterprises in the 1990s. These non-performing loans across China's banks were estimated to be as high as 40% of total loans outstanding. To fix the problem, authorities disposed of the non-performing loans by transferring them to four government funded asset management corporations (AMCs), a version of the much vaunted Swedish model that was used to fix that country's banking system in the early 1990s.

China's banks were again cleared of bad loans and recapitalized prior to public stock flotations in 2005 and 2006. Since that time, banks balance sheets have looked better than ever and non-performing loans (NPL) plummeted. The ratio of NPL to total assets for China's largest banks was down to 2% in April from over 12% in March, 2005.
We continue to believe China will lead the world out of the current economic crisis and current data confirms our view the current excessive rise in bank lending notwithstanding.

Emerging Markets Weekly

Last week we saw further signs of the emerging market trading blocs that are forming and that will eventually displace the old economic order. The US dollar is the world's reserve currency—the currency of choice for trade settlement. However, severe recession in the United States combined with a banking crisis is opening the door for China to increase its influence in the global economic theatre.

The recent visit of Brazilian President Lula Da Silva to China was significant in this regard. Calls this week by Da Silva to establish trade settlement in local currencies rather than dollars is an early sign of the rising influence of the RMB vis-à-vis the US dollar.

Recently, policymakers in Beijing called for a new international reserve currency to displace US dollar hegemony as the world’s reserve currency making it clear that China wants a place in the new economic order. China has signed 3-yr RMB/local currency swaps with Argentina and other emerging market countries-- a sign of China’s growing sphere of influence.

China is now Brazil's biggest trading partner displacing the U.S. from the number one position, and recently, China signed a US$10-billion deal with Brazil to secure 200,000 barrels of oil a day (bpd) from Brazil's largest oil company, Petorbras, for the next decade. The deal is based on a $10 billion loan for Petrobras from China at below market rates.

Growing trade relations across emerging markets will serve to increase the prospects of the RMB gaining prominence as a reserve currency. One prerequisite for this to happen is the removal of controls on China’s capital account so there are no restrictions on the flow of its currency. Nevertheless these are the first signs that China is slowly increasing its sphere of influence in the global financial order.

Emerging Markets Weekly

The strong reboundin BRIC stock markets since November confirms our research last fall that suggested these markets were highly undervalued and that rebounds would come quick-- and that they would be big. Indeed, the rise in these stock markets have been very impressive. The gains since November for Brazil, China, India and Russia are 57%, 64%, 29% and 51% respectively in Canadian dollars as of May 7th according to data from MSCI Barra.

One of the interesting characteristics of these rebounds is that they came well in advance of the bottom of advanced economy stock markets. However, one would think that expectations for an early recovery of the U.S. economy from recession are driving gains higher in the near term. The extension of this rally may ultimately depend on economic recovery in the developed world. In that event, there is good reason to believe more gains will come.

It is worth pausing at this point in the rally to take a look at valuations to make sure that prices are not too far ahead of fundamentals. It is clear that stock markets discount economic recoveries roughly six months in advance of the fact. So valuations undoubtedly rise in these circumstances.

A look at P/E ratios for Brazil, Russia, India and China shows that valuations have indeed bounced off the absolute lows seen last November. Valuations in China appear to have run ahead fastest. Thecurrent P/E ratio for the MSCI Brazil Index at 12 is close to its long term average of 13; China is trading at a P/E of 12, just above its long term average of 11; India is trading at a P/E of 14 below its long term average of 17; and Russia is undoubtedly the cheapest market with a P/E of 4 below its long term average of 15

Valuations are clearly not excessive at this juncture and past experience suggests that an economic recovery will coincide with a continued rise in valuations above long term averages. We will continue to monitor valuations for this risk, but currently we are nowhere near this point.

Percentage Gain Since Market Bottom:

Emerging Markets Weekly

The current global economic crisis is an opportunity for Brazil to see convergence in real interest rates several years after the country successfully put the inflation genie back in the bottle. This change will result in a permanently higher potential rate of growth for the economy says Guilherme da Nobrega, chief economist of Itau Securities in Brazil.

Brazil suffered from hyperinflation that relegated the economy to weak growth before the government introduced the Real Plan in 1994. Consumer price inflation has finally come under control since 2005 around the central bank's central target of 4.5%, but real (inflation-adjusted) interest rates have remained stubbornly high -- close to 10% since 2000.

Brazil should arguably have a much lower real interest than it has experienced over the past few years but rising inflation due to cyclical pressures in 2008 raised questions about the ability of the central bank to control inflation. This factor delayed a fall in real interest rates associated with the falling debt to GDP ratio this decade.

Now that commodity prices and inflation are declining in Brazil due to the global economic recession, Brazil will see real gains in terms of lower real interest rates over the medium to long term. The fall in real interest rates will result in lower debt service costs on the government debt valued at roughly 60% of GDP, and will allow the economy to achieve a higher trend rate of growth.