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Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 19 Feb 2010 14:54:00 +0000

There has been a lot of water under the bridge since Goldman Sachs released its initial report in 2003 detailing the growth potential of BRIC nations by 2050. Seven years later, the analysis looks prescient albeit too conservative. BRIC nations grew faster than expected and accounted for a greater share of the global growth than anyone might have imagined. Part of the reason for the superior growth performance of the BRIC nations versus the G7 countries is accounted for by the abject weakness of the latter countries since 2007. Yet the fact that the BRIC nations maintained strong annual growth rates despite the crisis is testament to their better economic fundamentals relative to the United States, Japan and Germany for example.

BRIC countries have therefore received a serious upgrade on an absolute and relative basis in the most recent report from Goldman Sachs that updates their economic projections for 2050. China, India, Brazil and Russia are now projected to occupy four out of the top five spots in terms of size measured by GDP in US$ at market exchange rates. The outlook for China is greatly improved in terms of absolute GDP which is perhaps not surprising given that in light of recent strength in China and expectations for China to move ahead of Japan this year to become the second biggest economy in the world.

The end point of convergence is admittedly 40 years off and there will be setbacks along the way to be sure. However, it is hard to argue with the logic that there are far greater opportunities for long term investors in the emerging markets over the long term.

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 12 Feb 2010 14:54:00 +0000

The global trade rebound over the past year has been largely unreported but represents an important development for export oriented countries such as China. What has been widely reported is the export-led economic slowdown in China in the fourth quarter of 2008 due to the global credit crisis, capital flight from China and the sharp fall in global trade. In response to the abrupt slowdown in China’s economy, policymakers enacted a US$586-billion fiscal stimulus in conjunction with a very aggressive monetary stimulus through the banking system. What is notable about the sharp growth rebound is that it was dominated by fixed asset investment although retail sales did expand strongly over the past year from a low base.

What is encouraging now, is the fact that exports have rebounded strongly since March 2009 which represents the nadir for the global credit crisis. Exports basically fell off the map as the chart below illustrates. After peaking at roughly US$140-billion in October 2008, they were cut by more than half up until they bottomed at close to US$60-billion in March 2009. Notice the impressive rebound in exports over the balance of the year where they finished just shy of the high water mark in 2008.

The rebound in exports is important because China has been heavily reliant on government stimulus over the past year and needs to move to a more balanced form of economic growth. While it will take several years to rebalance the economy toward domestic demand, the rebound in trade is a very important development from a near term perspective.

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 05 Feb 2010 14:53:00 +0000

Russia appears to be significantly less advanced than the other three BRIC countries in terms of inflationary pressures and therefore in its need for tighter monetary policy. Inflation is actually falling in Russia unlike the experience for Brazil, India and China where inflation has been rising on a monthly and annual basis since the end of 2009. That goes part way to explaining why equity prices in Russia bucked the recent sell off and actually appreciated over the past month in the face of a global equity market correction.

Russia’s economy has been slower to respond to the global economic recovery with manufacturing activity only recently turning positive; the purchasing manager index signaling expansion (50.8) in January after contraction in the final quarter of 2009.

Whereas inflation was high and rising in January 2009, hitting over 13% due to a depreciating ruble, that issue proved fleeting, and inflation has subsided over the past year. Inflation fell to 8.8% in December 2009 taking pressure off the central bank to tighten policy.

In fact rates continue to come down and are currently sitting at 8.75% after a series of interest rates cuts in response to the weaker economic environment.

The other encouraging front in Russia is equity valuations. The market trades at roughly a PE ratio of 8.4 and price to book ratio of 1.1 based on a US$70 oil price according to research by Troika Dialogue suggesting that Russian equities remain cheap even after a doubling in share prices in 2009. Lets not forget that valuations were at bombed out levels back in March of 2009 trading on a historical PE basis of less than 4 according to data from MSCI Barra.

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 29 Jan 2010 14:50:00 +0000

The message was right but the timing was all wrong when the IMF released an update to its World Economic Outlook last week, announcing that “risk appetite has returned” just as global financial markets were choking on the olive pit of Greek government finances.

Market sentiment shifted over the past week from hope to worry with particular focus on policy tightening in China and the prospects of sovereign default in Greece. The latter issue looks real and intractable with Greece getting knocked out of the European Monetary Union a distinct possibility within the next two years. Policy tightening in China to curb runaway loan growth is a buying opportunity however.

Investors are fretting that as Beijing reins in its bankers from handing out loans as freely as advice that China’s economy will come crashing down. Speaking of advice, Confucius said that, “He who will not economize will have to agonize,” and a little prudence in lending is no bad thing.

Investors are missing the fact that Beijing is simply taking its foot off the accelerator rather than hammering on the brakes. They are still planning to extend nearly twice as many loans in 2010 (in value) as in 2008. And turning back to the IMF update, the global economy is expected to grow 3.9% in 2010 and 4.3% in 2011, a two speed recovery to be sure with emerging economies in the fast lane growing 6% this year and 6.3% in 2011 according to IMF estimates. The advanced economies will see growth of only 2.1% this year and 2.4% in 2011. China is expected to grow 10% in 2010 and 9.7% in 2011.

The MSCI China Index and the Hang Seng Index in Hong Kong have corrected 10% since January 11th setting up a buying opportunity for the next leg of the bull market.

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 22 Jan 2010 19:08:00 +0000

It may be decades before incomes in emerging markets approach developed market levels, yet it seems clear that the sheer size of these populations means that consumer markets are already very powerful forces in many emerging markets.

It is astounding to learn that there were only 6.5 million mobile phone subscribers in India in 2002. The market simply exploded over the past decade as incomes rose and credit became widely available. Currently India boasts more than 500 million cellular subscribers according to the Telecom Regulatory Authority of India.

In China, retail sales rose nearly 17% in 2009 in real terms, up from roughly 15% in 2008. China now boasts an auto market that surpassed the United States in volume making it the biggest market in the world.

Of course we are at a very early stage of development of these markets given the fact that per capita incomes in the emerging markets are a fraction of incomes in developed markets. That is why, China’s auto market is projected to grow to double the size of the U.S. market in just ten years according to Goldman Sachs and India’s cellular market will likely double in only five years time according to the Telecom Regulatory Authority of India.

Gross national income per capita for Brazil, Russia, India and China was $5910, $7560, $950, $2360, respectively in 2007 according to the World Bank; low by our standards. As incomes grow over the next two decades, these consumer markets will eclipse markets in the developed world.

Companies have recognized this trend and many are thankful for their emerging market exposure over the past year given the weak state of consumer markets in the United States, Europe and Japan. For example, GM saw sales growth of 66% in China in 2009 to 1.8 million units versus roughly 1.9 million units in the U.S. in the first months of 2009. This is a trend that is playing out in Emerging Markets with new first time consumers!

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 08 Jan 2010 15:19:00 +0000

A quick look at valuation in emerging markets reveals that the BRIC countries are no longer trading at the discounts to long term averages that they were trading at last year at the height of the financial crisis. The chart below shows the trailing P/E ratio for the four BRIC markets revealing that Russia appears to offer the best value and that neither India nor China are anywhere near the high points reached prior to the onset of the global credit crisis.

One way to look at the rising P/E ratios is that the market is discounting a strong rebound in economic growth in 2010. In India for example, analysts are expecting a 24% rise in earnings for the fiscal year ending March 2010. If these earnings materialize as expected over the course of the year, there is every reason to believe the market could move higher because valuations would otherwise recede to their long-term average.

Given the similarities between valuations in emerging markets and developed market on a trailing P/E basis, it would seem obvious that the higher growth prospects in the EM make these markets a better bet.

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 18 Dec 2009 17:43:00 +0000

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

noreply@blogger.com (Levi Folk) — Fri, 11 Dec 2009 20:00:00 +0000

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

noreply@blogger.com (Levi Folk) — Fri, 04 Dec 2009 14:42:00 +0000

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.

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 27 Nov 2009 16:43:00 +0000

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

noreply@blogger.com (Levi Folk) — Fri, 20 Nov 2009 14:29:00 +0000

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

noreply@blogger.com (Levi Folk) — Fri, 13 Nov 2009 17:25:00 +0000

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

noreply@blogger.com (Levi Folk) — Fri, 06 Nov 2009 16:10:00 +0000

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.

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 30 Oct 2009 16:22:00 +0000

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:

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.

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.

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

noreply@blogger.com (Levi Folk) — Fri, 23 Oct 2009 15:19:00 +0000

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

noreply@blogger.com (Levi Folk) — Fri, 16 Oct 2009 19:12:00 +0000

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

noreply@blogger.com (Levi Folk) — Fri, 02 Oct 2009 18:08:00 +0000

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.

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 25 Sep 2009 15:03:00 +0000

At the start of the year, in the midst of the financial crisis, we were quick to point out the extremely low valuations in emerging markets and the once in a lifetime opportunity for investors to buy in to multi-year growth stories on the cheap.

After a dramatic recovery and phenomenal gains over the past year, the world’s stock markets no longer appear cheap—with the exception of Russia for one. Back in February, Russia’s stock market was phenomenally cheap. Yet even after 70% plus gains this year to date, Russia’s stock market remains a buying opportunity for investors with suitably long time horizons.

The MSCI Russia Index is still undervalued based on historical valuation measures and Russia’s economy is recovering after a very difficult year. The index trades at a price earnings ratio of roughly 7, roughly half its average valuation based on data on record dating back to 1996.

Russia’s economy will grow roughly 3% next year after contracting more than an estimated 8% in 2009. Retail sales and investment are weak, but a rebound in in oil prices, economic recovery in the developed world, and softer inflation will allow Russia’s economy to pull out of economic decline and recover. The country boasts low levels of public debt and high foreign exchange reserves that have allowed the central bank to stabilize the currency.

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 18 Sep 2009 14:29:00 +0000

The long term growth potential of India’s market is at times questioned by the high level of government indebtedness in contrast to, say, China’s low level of government debt. At 80% of GDP, India’s high level of indebtedness is a potential drag on growth in the near term and calls for fiscal consolidation now the economy has recovered. The general government budget deficit including off balance sheet items such as subsidies on fertilizer and oil consumption exceeds 10% of GDP. Fortunately, India is in the envious position of having a very high potential rate of GDP growth that will allow it to stabilize its debt more easily than developed nations.

For example, as long as the economy can grow 8% a year over the long term, the debt to GDP is manageable because the rate of growth of the GDP will exceed the growth rate of debt caused by interest payments. Assuming real interest payments on debt of 3% per annum, the government could run a fiscal deficit in excess of interest rates (primary deficit) of 5% to stabilize the debt to GDP ratio. Moreover, the government has long term plans to reduce the national debt by selling off state assets worth an estimated 30% of GDP. If that transpires, which will undoubtedly happen slowly, interest payments on debt will fall.

As India’s economy recovers this year, its economy is expected to grow between 6% to 7%, weaker than recently expected due to a poor monsoon. Investors need to keep a watchful eye on India’s ability to return to its long term potential rate of growth of 8% of GDP. The sooner that the economy recovers and output rises, government finances will recover more quickly and government debt will be stabilized.

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 11 Sep 2009 13:47:00 +0000

Despite concerns in the media that China is about to kill off its economic recovery with tighter monetary policy, the opposite appears to be true. Policymakers appear determined to ensure that China achieves 8% economic growth that is believed to be their unofficial growth target. The economy rebounded in the second quarter to year on year growth of 7.9% and appears likely to exceed that number in the third quarter of this year.

Bank credit is expanding at a 30% year-on-year pace since March 2009, fuelling a tremendous expansion in investment associated with the US$586-billion stimulus plan that was unveiled at the start of the year. The focus of the plan is on infrastructure spending, and it is proceeding according to plan judging by the rollout of projects including rail expansion, airport development, etc. It is evident in the data on fixed asset investment-- up 33% over the year to August.

The government budget deficit of 4.5% for 2009 and net debt of 20% of GDP suggests that the government is well within its limits to boost output this year and next. Investors should bear in mind that the stimulus spending will roll out over the current year and next, so there is plenty more ammunition to carry China’s economy forward to 2011 in expectation of a global economic rebound.

Inflation continues to print negative in China, down 1.2% on an annual rate in August. Expect inflation to begin rising by the start of 2010 as higher oil and food prices start to hit headline numbers. Given the massive loan and money growth in China, we will look to China as one of the first place to see interest rate hikes in the first half of 2010. Nevertheless, risks of a double-dip recession are not a concern for China.

China data for August (year-on-year %):

CPI: -1.2%
PPI: -7.9%
Fixed Asset Investment: 33.0%
Retail Sales: 15.4%
M2: 28.5%

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 04 Sep 2009 14:07:00 +0000

Even with a headwind of a high savings rate, the brute force of 1.3-billion people spending even a little more money thanks to rising incomes is propelling China’s consumer market forward. Savings may be falling as a percentage of total output, but incomes are rising making the consumer market in China an unstoppable force that will see urban consumer spending grow five-fold between 2006 and 2025 to US$2.3-trillion according to a report by McKinsey Global Institute (MGI), catapulting China’s consumer market to the third spot globally.

A middle class is taking shape in China-- accounting for roughly one-third of the population today from virtually nothing in 1990 and set to rise to 70% of the population by 2020 according to MGI. At US$3000 in annual income, the threshold for entering the middle class may sound despairingly low by our standards, but it is the point in the developing world where households start buying non-discretionary items beyond food and housing, bearing in mind that the cost of goods is far lower in emerging markets such as China.

Look no further than the mobile phone industry to capture the imagination of the potential for China’s domestic demand. Each month, the mobile phone industry lifts its net and snags an additional 10-million subscribers or so to add to the 650-million people already with mobile phones in China.

At the high end of middle class incomes, car purchases will surely be a major focus of status-hungry consumers. China now has the second largest highway network in the world and leapfrogged the United States to the position of number one car market in the world this year. Given that the auto market is in its infancy, the prospects for car companies over the next decade have auto executives in rapture.

Domestic companies have two natural advantages over foreign competitors: cultural knowledge and established distribution networks; many also benefit from government regulation. Foreign multinationals may have initial success in the four tier one cities (Shenzen, Shanghai, Beijing, and Guangzhou) in China where they are “out-marketing” the competition says Jonathan Chajet, Managing Director for Interbrand China, but they are finding that a great deal of spending comes from the 37 tier two cities and the 136 tier 3 cities with populations greater than 1-million inhabitants. These tier 3 cities represent more than half of all disposable income in China, according to MGI.

It is astounding to think that China has the largest auto market in the world when only 0.5% of the population owns a car in contrast to the United States where 80% of the population owns a vehicle. It is the same story for so many goods and services in China. The growth potential is astounding.

To read the full story at National Post click here:
http://www.nationalpost.com/story.html?id=1963896

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 28 Aug 2009 15:37:00 +0000

In recent weeks, I have been reading a great deal about the China stimulus package and the potential for overcapacity due to the overwhelming focus on investment and infrastructure spending. The sentiment is clearly turning, call it phase three in the global slowdown and China recovery story.

The first phase was dominated by selling and fears that China was headed for a massive recession. The second phase was the turnaround story for both the economy and the stock market as the doubters eventually came onside to the recovery view. And finally, phase three is a transition to renewed fears, this time about the sustainability and quality of the growth.

These are good questions to ask, and there is undoubtedly validity to the concerns that China is spending its way out recession through brute force. There will be overcapacity and low returns to many projects.

On the other hand, retail sales figures are encouraging. The data shows that retail sales volumes have jumped considerably over the past year thanks to the stimulus package. It is difficult to tell how reliable the data because it is purported to include some government and corporate spending.

Nevertheless domestic consumption growth is a response to government stimulus measures. Auto sales for example are very strong—with China recently leapfrogging to the number one spot in global auto sales.

Investors need not fear a collapse in spending in the near term because the stimulus extends to 2010. Bank lending is being reined in and that is evidenced by a slowdown in lending and the money supply between June and July but the authorities are not about to slam on the breaks too hard.

It will take policy makers years to rebalance China’s economy from saving toward consumption, and the path forward will not be straight. But over the next fifteen years, hundred of millions of people will urbanize, their incomes will rise and so too will consumption as the middle class grows.

If we have to choose between the U.S. economy that can barely eke out growth with trillions of dollars of stimulus or China’s that is responding to its stimulus package and over the long term has so much greater potential for growth, I take China, hands down.

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Sat, 22 Aug 2009 00:00:00 +0000

Up until last fall, most currencies of emerging market countries appreciated strongly versus the US dollar and to a lesser extent against the Canadian currency. This extra kicker to equity returns, reversed at the time that equity markets fell in the emerging countries last year with the notable exception of China, where the RMB largely stopped appreciating.

The slowing of foreign direct investment and reversal of portfolio flows led to this currency weakness despite large U.S. dollar foreign exchange reserves in the BRIC countries, China once again being the exception to this rule. The large foreign currency buffers did allow central banks the ability to manage foreign currency depreciation when the crisis was at its peak.

In China's case, authorities have resisted the natural currency appreciation that would have occurred due to the country's very sizeable trade surplus that exceeded 10% of GDP for several years. Moreover, capital flows did not turn sufficiently negative to significantly reduce the $2-trillion plus worth of dollar reserves at the central bank's disposal. Authorities also made it clear that they would not seek a policy of competitive devaluation with the RMB to boost trade but opted instead for fiscal and monetary stimulus measures.

The strengthening positions for the emerging markets this year means that currency appreciation is back on the table-- and has been happening. Over the long term, we should expect to see a rise in exchange rates for the BRIC countries due to higher rates of productivity in their tradable goods sectors. Therefore, India and China would benefit most from this phenomenon. The Balassa-Samuelson effect is the formal name for this theory that seeks to explain why price levels tend to be higher in higher income countries. The answer alluded to here is that higher productivity in tradable goods is the reason and explains why countries such as China and India with higher rates of productivity in the tradable goods sectors should experience appreciating exchange rates over the long term.

It is this phenomenon why investors will get a foreign currency headwind from investing in emerging markets.

Emerging Markets Weekly

noreply@blogger.com (Levi Folk) — Fri, 31 Jul 2009 13:53:00 +0000

The end of the easing cycle of monetary policy appears to be upon us in China and India, months or perhaps more than a year before the developed market tightening cycle begins. India and China enacted very aggressive monetary policies beginning late 2008 to combat the global economic recession. Those policies have achieved a high degree of success achieving measurable growth rebounds. Policies will now start to transition from growth stimulus to inflation control.

Inflation in the emerging markets peaked in the summer of 2008 with the collapse of the global economy and the plummet in oil prices. The fall in inflation allowed central bankers to focus exclusively on growth. Policy rates were lowered aggressively across the emerging markets with the exception of some countries that had significant capital flight.

Investors should expect that interest rate cuts in India and China have run their course and that a focus on inflation will rise to the fore in 2010. In China, very loose monetary policy has led to exceptionally strong credit and money supply growth. While this outcome is not a visible concern for authorities, lending rates clearly needs to be reined in over the next year.

Inflation is now rising on a monthly basis even if it is still falling on year over year comparisons in China. What this means is that inflation pressures are only just starting to rise, and it will be several months before inflation rises on a yearly basis. Nevertheless, the fact that inflation has bottomed suggests that interest rate cuts have now reached their conclusion. Recent reports that China's two largest state owned banks announced limits on new loans for 2009 supports this claim.

In India, the Reserve Bank of India stated in its July 28th monetary policy statement that industrial production activity is picking up and that inflation concerns were starting to surface. Similar to China, annual inflation is negative, but monthly inflation is beginning to rise.

We view these developments positively because they confirm that the global economic recovery is happening in the emerging world. We also believe that the pick up in pricing power will lead to an earnings recovery in the near term. It is too early to begin fretting about tightening policy because inflation is only just bottoming, but we are following these developments over the next six months with a watchful eye.