Emerging Markets Weekly

The long term potential for real currency appreciation in the emerging markets is often discussed but little understood. It is based on established economic theory (Balassa-Samuelson effect) that suggests currencies will reflect differences in productivity levels in the tradable goods sector between developed and emerging markets and that rising productivity in emerging markets means wages and prices will rise in the emerging markets over the long term.

If you ever noticed that prices are lower for non-tradable goods and services in emerging markets, haircuts for example, but tradable goods necessarily must reflect global market prices. Since productivity is lower in emerging markets, wages are lower too. The difference in prices at the current exchange rate represents the level of undervaluation of a given currency and the potential for real exchange rate convergence between emerging and developed markets over the long term, toward purchasing power parity (PPP). China’s currency is 50% undervalued based on PPP estimates according to a recent study, for example.

As productivity rises in tradable goods sectors in the emerging markets, incomes rise and prices of services such as haircuts are bid up too, even though productivity does not rise for these services (a haircut is a haircut). Eventually the price of these services rise relative to the price of tradable goods implying that real currency undervaluation will disappear over the long term.

Therefore, as incomes rise in the emerging markets over the long term and converge toward developed market levels, exchange rates are expected to converge toward PPP levels.

The Economist newspaper published an annual Big Mac Index that considers currency under/overvaluation based on PPP using the price of a Big Mac as the yardstick of measurement. This rough and ready measure suggests that the Chinese RMB and Russian ruble are roughly 50% undervalued based on PPP.

Emerging Markets Weekly

Anyone in doubt about the opportunities in banking and other financial services in BRIC markets should consider the opportunity for credit growth to the household sector over the next decade and well beyond. While mortgage lending in the United States, UK and other developed markets hit its pinnacle in 2006 due to very lax lending standards and low interest rates, those markets are in the process of unwinding from an unsustainable credit boom.

Emerging markets also experienced a lending boom over the past decade but crucially from a much lower base. Credit penetration in the BRIC markets remains exceptionally low with mortgage credit currently less than 10% of GDP in contrast to the Unites States where mortgage credit is equal to nearly 75% of GDP. The contrast in numbers is an encouraging indication of one of the many opportunities in banking in the BRIC countries as households gain access to mortgage credit in Brazil, Russia, India and China for the very first time.

It is expected that banks in the developed world will continue to shrink assets and assume less leveraged balance sheets over the next few years as regulators attempt to get a better handle on risks in the financial system. In contrast, it is expected that banks in the emerging markets will undertake significant loan growth due to the lower gearing that they have carried over the past few years.

Not only will mortgage credit rise as a percent of GDP, but output will also rise much faster in the developing world with China now expected to experience output growth as high as 10% in 2010. This one-two combination means that the banking sector could easily see double-digit loan growth over the next few years.

Emerging Markets Weekly

Infrastructure development will continue to be a challenge for the emerging market economies and an opportunity for investors over the next two decades. Investors have voiced concerns that a lack of infrastructure development in India, particularly in power generation, will create natural speed limits to the economy over the long term—holding back growth and corporate profitability. A recent report by Goldman Sachs estimates that India will require US$1.7 trillion in infrastructure spending over the next decade to overcome these issues—a huge opportunity for investors to be sure but one that will be funded internally.

The good news is that Goldman figures that India can generate sufficient private savings to fund this development. It boils down to a favourable demographic picture whereby the median age of the population is currently 25 years, thereby leading to a rise in the savings rate over the next ten years and beyond as the population ages and as incomes rise, with the savings rate expected to rise to 40% of GDP by 2016. There is more to the story, however.

Corporations in India are operating with low leverage that will enable them to throw off sufficient cash as well to act as an additional source of funds to finance infrastructure development.

All told, infrastructure in India will continue to be a major opportunity for investors over the next decade, and banks will continue to be the intermediary for channelling savings into these projects suggesting that banks will also be an important part of this investment opportunity.