Emerging Markets Weekly

The last week offered an interesting test of the resilience of the current rebound in capital market prices— especially for emerging markets in light of the default by Dubai on debt issued through its wholly owned corporate entity, Dubai World. The announcement last Wednesday sent shudders through capital markets, leading to one well known portfolio managers to predict a 20% correction in emerging markets. The result, heretofore, has been a muted cementing of the general impression put forward in this column that emerging markets are less risky entities and less exposed to external shocks in global capital markets than before.

It is highly noteworthy that emerging market bonds in the likes of India and China have experienced capital inflows over the past week. These markets are understood to be less risky than many bond markets in the developed world where heavily indebted countries experienced selloffs— most notably Greece and Italy.

The Dubai World incident raises the issue of how tighter liquidity will affect different borrowers with high debt loads. While it is still early to contemplate, the events of the past week provide a nice test for emerging markets in the event of these external shocks and the grade is a resounding pass.

Emerging Markets Weekly

One after effect of the recent credit crisis is that investors are on alert for market bubbles with heightened sensitivity, with China being the most recent object of attention. The phenomenal credit growth in China this year is reason for speculation that China’s market is in yet another bubble about to burst, but it seems largely unfounded. Sure, property market speculation has been rising, but to call the stock market a bubble is to misunderstand the concept.

A market bubble occurs when prices become divorced from fundamentals. True, they tend to occur in a mania type environment — and the 98% rise in the MSCI China Index over the past year has investors thinking they are seeing a market mania. However, let us not forget that the market fell heavily in 2008 and the rise this year does not even come close to getting us back to past highs. In fact, the MSCI China Index is still 38% below its previous high reached last in 2007, suggesting that the current market rally is anything but a bubble.

Valuations are also another indication that the market is not a bubble. Based on price-earnings ratios, the MSCI China Index is trading around its long term average based on 2010 earnings. The market is no longer cheap, but that does mean it is a bubble.

Emerging Markets Weekly

The past week has seen another surge in China’s economy into overdrive. Industrial production increased 14% in the three months to October suggesting that GDP growth could hit 10% in the final quarter of this year. Authorities are naturally considering monetary tightening and have signaled a desire to move toward currency appreciation over the next year. This policy is highly desirable from several standpoints.

Firstly, the RMB needs to rise so China can pursue monetary policy independent of the U.S. Federal Reserve Bank. By keeping the RMB tied to the U.S. dollar, Beijing is implicitly following U.S. monetary policy which is highly accommodative-- too much so for China’s fast growing economy. The carry trade, whereby investors borrow in a low funding currency such as the U.S. dollar and invest in China’s markets is one aspect of this link in monetary policy. By pegging the RMB to the dollar, China is flooding its own economy with RMB when it takes in U.S. dollar reserves. A better policy is one where the RMB appreciates allowing authorities to better control the domestic money supply.

A higher RMB is also desirable from a global trade perspective. China needs to move away from an export driven economy, and a higher currency would encourage imports and discourage exports. It would also allow China to reduce its intake of dollar reserves which would stem its purchases of U.S. Treasury bonds, currently sitting at close to US$800-billion. This would allow for a long term rise in U.S. bond yields that would reduce household borrowing and eventually rebalance the U.S. economy away from its perpetual deficits on trade.

Investors should therefore expect a tailwind from currency appreciation over the next year.

Emerging Markets Weekly

The recovery in the global economy does not suggest business as usual for the economic order. Rather, emerging markets are reverting toward trend rates of growth much quicker than the developed world. Moreover the BRIC countries appear to have fast-tracked in importance to the global economy. Between 2002 and 2007, the BRIC countries accounted for roughly 38% percent of global economic growth on average. Since then, they have risen in prominence. This year, in what will prove to be the worst year for the global economy in decades, the BRIC countries are expected to add 1 percentage points of growth to a contracting global economy, a feat never before achieved. In other words, without BRIC, global GDP would have contracted a further percent this year.

Next year, the BRIC countries will have recovered much of their past swagger but not so the global economy due to weakness in the advanced economies, according to IMF estimates. The BRIC countries will account for more than half of global growth in 2010 adding 1.6 percentage points to growth. It remains to be seen whether the advanced economies will regain their dominant place in the global economic order, but high levels of indebtedness for the advanced economies suggest that the change may indeed be permanent.