Emerging Markets Weekly

More than a year after the credit crisis and the BRIC nations, Brazil, Russia, India, and China have the wrested the growth momentum from the developed world in convincing fashion. The BRIC countries have rebounded from the crisis well ahead of the developed world with the exception of Russia’s economy that was hit hardest of the four this year. China’s economy grew strongly in the third quarter of 2009 posting GDP growth at an 8.9% rate representing a remarkable return to form for the world’s most populous nation.

The economies of India and Brazil have bounced back smartly too and Russia’s though slower to recover is benefitting greatly from higher oil prices recently. These economies were able to rebound quickly because of superior economic policies pursued over the past decade vis-à-vis the developed world. The most important policy initiatives are as follows:

1. Well capitalized banking systems: It is worth reiterating that the banking systems in China, Brazil and India were not greatly affected by the credit crisis for several reasons. Firstly, the banking authorities were far more conservative in regulating the banking sector. In Brazil, India and China, a mix of policies ensured that banks were better able to withstand economic recession. Brazil also required banks to hold bigger capital buffers and had more conservative measures of what constituted capital as well as high reserve requirements on bank deposits.
   
   In China, government policy to recapitalize the banking system in the late ‘90s and early ‘00s ensured that China’s banks had very big capital buffers leading into the crisis. In India, convertibility restrictions prevented banks from getting overseas exposure, and banks were also well-capitalized heading into the crisis.



2. High Foreign Exchange Reserves: Currencies were protected by large caches of foreign exchange reserves dominated by U.S. Dollar holdings. Each of the BRIC nations had hundreds of billions of dollars of forex reserves at their disposal to manage the capital flight that took place when the credit crisis hit. China, most notably, has roughly US$2.3 trillion of foreign exchange reserves, but Russia was able to use roughly one-third of its US$600-billion in foreign exchange reserves to manage the depreciation of the ruble.



3. Low levels of foreign indebtedness. High commodity prices leading into the crisis allowed Russia and Brazil to benefit from strong government revenues derived from national commodity production. Moreover, Brazil’s government pursued conservative fiscal policies that led to a dramatic fall in net foreign debt and falling inflation this past decade. Only India was hampered by a high and nagging budget deficit. As a a result, these countries have been able to purse Keynesian style stimulus programs to offset the fall in output caused by weak global exports without raising questions about long term growth prospects.

Emerging Markets Weekly

Last week in Brazil, authorities announced a 2% tax on foreign purchases of stocks and bonds to stem the tide of currency appreciation. The tax sent a brief shockwave across capital markets, but they have since recovered suggesting that investors are not overly bothered by the tax. At 2%, the tax represents just a fraction of the rise in the stock market and the currency this year.

The real has appreciated 35% against the dollar this year on higher commodity prices and a credit rating upgrade by Moody’s, and the central bank action led to only a 2% fall in the value of the real on the day. Policymakers may be concerned about the strength of the currency and its threat to the competitiveness of the country’s manufacturing sector, but the currency is rebounding from a sharp decline last year. Moreover, Brazil’s is a relatively closed economy with exports accounting for only 15% of GDP.

The move led to a roughly 2.9% fall on the day by the main Bovespa Index and a subsequent 1% recovery the subsequent day confirming the fact that a 2% tax will have little lasting impact on the currency and the stock market.

China may have one of the most undervalued currencies in the emerging markets suggesting that trade could soon start contributing to GDP growth (last week also brought third quarter GDP results for China that showed GDP growth expanding 8.9% on the quarter), but investors need not be overly concerned by the strength of the real. Versus China’s yuan (China is Brazil’s number one export destination), Brazil’s currency is roughly flat since the beginning of 2008. The currency is merely recovering lost ground given up during the global credit crisis.

Emerging Markets Weekly

Despite significant gains in its stock market over the past year, Russia is rebounding from a brutal fall and still looks cheap for investors with suitably long time horizons. The country is home to undervalued oil assets and a banking sector that could expand at very high rates over the next two decades.

Russia now boasts the status as the world’s biggest monthly oil producer since Saudi Arabia has borne the brunt of OPEC production cuts over the past year. The collapse in oil prices last year devastated Russia's economy and stock market. GDP contracted more than 10% in the first half of the year, and the stock market fell 75% from peak to trough.

The country is only now turning the corner from economic recession to recovery and looks set to expand between 3% to 4% in 2010. Moreover, economic output will remain below trend for the next several years, and the government is attempting to make up for the shortfall through fiscal stimulus.

Cost cutting combined with a return to top line growth at the corporate level will result in earnings growth of 60% on an annualized basis between 2009 and 2011 according to Goldman Sachs, who sees a potential for 40% further upside to the market through 2011 assuming oil prices rebounding to US$110 per barrel.

"Oil is very interesting because energy companies in Russia are the cheapest globally, and demand from emerging economies is going to be higher," says Ghadir Abu Leil-Cooper, head of Europe Middle East and Africa equities at Barings, and manager of Excel Emerging Europe Fund reached in London. Moreover Russia’s banking industry is also highly attractive over the long term given the low credit penetration with mortgages accounting for only 2.5% of GDP currently.

Emerging Markets Weekly

The resilience of the emerging markets in the current financial crisis is best captured in recent IMF forecasts for global GDP growth this year and next. Advanced economies are not only subtracting from global output in 2009, they are the cause of the contraction. In contrast, emerging and developing economies are tapped to grow 1.9% in 2009. The same picture largely emerges in 2010. World output is pegged to rebound fairly strongly to 3.1% growth with the developed world delivering tepid growth of 1.3% and the emerging world turning in growth of 5.1%. In other words, the developed world is no longer the growth engine of the global economy.

This goes back to the greater resiliency of the emerging economies in the current crisis relative to past downturns. The result is all the more impressive given the severity of the current crisis. It seems clear that emerging equity markets overreacted to the downturn given their swift recovery and given the resilience of government bond markets. In previous cycles, U.S. High yield debt and emerging market sovereign debt performed similarly. In 2002, yield spreads on the Emerging Market Bond Index (dark blue, right graph) indicated that investors judged the risk of default by emerging countries higher than the risk of default by U.S. sub investment-grade borrowers (yellow line, right graph).



In contrast, the current crisis raised the perceived and actual default risk of U.S. high-yield borrowers relative to emerging market sovereign borrowers. In other words, emerging markets were in far better shape this time around. The reasons are manifold including high foreign exchange reserves, low levels of debt and fiscal deficits, and reduced foreign currency exposure in many key emerging markets. These factors have allowed the emerging markets to achieve stronger and faster economic recoveries relative to the advanced economies and suggests that their leadership role could continue for the next several years.