Where To Next For Emerging Markets?

An expanding middle class and strong long-term fundamentals suggest that pessimism over developing nations’ economic prospects may be overdone.

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At the World Bank/IMF meeting in Lima in October, delegates spoke of little else but emerging markets. On the conference podium and at receptions, the fate of countries that, until recently, were considered the dynamos of the global economy dominated conversation. Opinions ranged from the apocalyptic to the quietly concerned, but most delegates agreed that emerging markets face one of their most critical challenges since the term was coined back in 1981.

To be sure, emerging markets have had their ups and downs in the past. Anyone who lived through the Asian crisis of 1997–1998 appreciates that the rise of emerging markets has been far from smooth. But the magnitude of the current predicament is different for a number of reasons.

“There are great opportunities as a result of the Chinese tourism wave. It is only in recent years that many Chinese have taken their first trip abroad.

~ Hyung Jin Lee, Baring Asset Management

First, despite some notable exceptions, emerging markets as a group appear to face significant problems, whereas previous crises have been region- or country-specific. Second—and more important—emerging markets matter more than they did in the past.

The reconfiguring of the global economy in the aftermath of the financial crisis of 2008 put emerging markets in the driver’s seat. Although the US has sprung back to life since then, emerging markets play a much bigger role today than they used to, accounting for 52% of global GDP compared with 38.3% just 15 years ago, according to global advisory firm Oxford Economics. As a result, when the emerging markets sneeze, the rest of the world is more likely to catch a cold.


Gloomy sentiment toward emerging markets has been reflected in sharply weaker capital flows in recent months. In its October report, the Institute of International Finance (IIF) said it expects 2015 net capital outflows from emerging markets of some $540 billion—the first time they have been negative since 1988. “Foreign direct investment, portfolio investment and commercial bank flows have all fallen from 2010–2012 levels, driven by increasing concern about emerging markets’ growth outlook,” says Charles Collyns, chief economist at the IIF. “This year the largest component of the decline has been the unwinding of dollar bank loans to Chinese corporates as the renminbi has weakened.”

The reversal of capital flows from emerging markets has potentially significant implications. Countries that run sizable current-account deficits and rely on external financing could face a damaging squeeze, according to Collyns, especially once the Federal Reserve begins to raise US interest rates. A faster-than-anticipated rise in US rates—such as might occur if inflation picks up, for example—could put further pressure on capital flows to emerging markets as these markets’ relative attractiveness wanes, for institutional investors and commercial banks alike.

Not all emerging markets are affected to the same extent. A recent Standard & Poor’s report entitled Who’s At Risk? notes that Turkey, Lebanon and Venezuela, followed by Hungary and Argentina, are the most vulnerable to a spike in global interest rates, given their high external debt relative to current-account receipts and foreign exchange reserves. The Philippines, China, Russia, Brazil and Peru are the least vulnerable, as their external balance sheets and financing needs are typically low.


Two closely linked factors are principally responsible for making many emerging markets more vulnerable to shocks—both internal and external—while slowing their economic momentum: the apparent end of the commodity supercycle and the changing economic model of China, whose growth rate has slowed.

The commodities supercycle—a period lasting roughly from the late 1990s and early 2000s to a couple of years after the financial crisis, during which the price of oil rose more than 1,000% and that of copper almost 500%—is said to have ended in mid-2013. For many observers, the halving of the price of oil since its mid-2014 peak has put the demise of the commodities supercycle beyond doubt.

The supercycle was driven mainly by historic underinvestment in commodities production, which meant supply could not keep up with booming demand (largely from China). When it did catch up, prices fell, with inevitable consequences for commodity exporters. The IMF’s October 2015 World Economic Outlook predicts that weak commodities prices will subtract almost one percentage point annually from commodities exporters’ average economic growth rate over 2015–2017, compared with 2012–2014.

At the same time, commodities demand has fallen dramatically as China has shifted its economic model away from exports and growth has slowed, exacerbating price falls. The redirection of China’s economy toward consumption has been well flagged. However, the task is massive and, unsurprisingly, progress has been uneven: Hitting the 7% GDP growth target has proved difficult. In October, imports—largely raw materials and components sourced from other emerging markets— fell more than 20% in dollar terms compared with the year-earlier period, while exports fell by 3.7%, sparking alarm.

Sizable corporate debt in emerging markets economies also raises risk for some. According to the IMF, the corporate debt of nonfinancial firms across major emerging markets ballooned from $4 trillion in 2004 to well over $18 trillion in 2014.

Apart from Argentina and Ukraine, which are a case apart, there have been no sovereign defaults, no significant increases in corporate defaults, no runs on FX reserves and no balance-of-payments crises.

~ Jan Dehn, Ashmore Investment Management

S&P expects $692 billion of rated financial and nonfinancial emerging markets corporate debt—7% of the global total of $9.9 trillion—to mature between 2015 and 2020. A large chunk of that corporate debt is in US dollars (75%) or euros (8%). That means issuers may have considerable FX risk.

As the dollar has strengthened against emerging markets’ currencies—not least as a result of the devaluation by China (whose companies account for $73.3 billion of S&P’s total)—S&P argues that it will become harder for companies to service their debt. “Issuers in emerging markets face risks of subpar economic growth, continued low commodity prices, depreciating currencies and the imminent rate hike by the Federal Reserve,” says Diane Vazza, head of S&P’s Global Fixed Income Research Group.

However, Jan Dehn, head of research at Ashmore Investment Management, notes that although some of these issuers are exporters and therefore have US dollar revenues, others may have hedges. Still others (notably in China and Russia) know they can rely on extensive central bank liquidity, if necessary. As a result, the currency risk highlighted by S&P may not be as great as feared.

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To put the challenges facing emerging markets into perspective, nobody ever expected these countries to continue contributing to world growth on the unprecedented scale of the past three decades. In the early part of that period, events such as the integration of China and the former Soviet Union countries into the global economy gave a one-off boost to growth. More recently, economic weakness in the US and Europe since the financial crisis has exaggerated emerging markets’ relative importance.

In this context, the recent performance of many emerging markets looks more attractive. China’s official 6.9% October growth figure dwarfs that of any comparably sized economy. The IMF expects emerging markets to grow at 4.5% in 2016, compared to an average of 2.2% for developed economies, and the agency has downgraded growth forecasts more steeply for developed economies than for developing ones. Furthermore, within the emerging markets average, some figures are impressive by any standards—the forecast growth of 7.5% for India in 2016, for example.

Moreover, several trends set in motion by the emerging markets boom still have a long way to run. For example, it might be assumed that China’s love affair with Africa’s natural resources will wane, given changes to its own growth model. However, George Fang, Standard Bank’s Beijing-based head of mining and metals in Asia, says China will become an increasingly important capital exporter in the coming years, which will prompt “even more investment by Chinese firms looking to tap Africa’s resource superstructure, as well as other sectors.”


Other emerging markets trends should also sustain growth. “Africa’s population will reach 2.5 billion by 2050,” notes Goolam Ballim, chief economist and global head of research at Standard Bank. “Equally important, the median age is 20, compared to 32 in Asia and 40 in Europe, while rapid urbanization is adding to the labor pool and increasing affluence. At the same time, financial services are deepening across the region as credit is made available, increasing consumers’ purchasing power.”

Indeed, middle classes across almost all emerging markets are burgeoning, making economies less reliant on external demand. According to research by European bank ING, the percentage of the world population defined as middle class will rise from 23%, or 1.8 billion people, to 52%, or 4.9 billion, in 2050. “As long as GDP growth continues to outpace population growth—as it does by some margin in Africa, for example—then purchasing power, and the size of the middle class, will grow,” says Ballim.

This wave of newly affluent citizens will have a profound effect on consumption. In the short term, consumption may face headwinds, such as weaker employment and real wage growth. But in the long term, the trajectory is clear. “Supportive demographics are driving Asian consumption on travel and leisure as well as cosmetics and healthcare,” notes Hyung Jin Lee, head of Asian equities at Baring Asset Management and manager of investment fund Baring Eastern Trust. “There are great opportunities as a result of the Chinese tourism wave, for example. It is only in recent years that many Chinese have taken their first trip abroad.”

Technology is also transforming established development patterns to emerging markets’ benefit. M-Pesa, a mobile money transfer service launched eight years ago, turned Kenya’s lack of fixed-line telecom infrastructure and limited banking reach to its advantage and has made the country the poster child for mobile money: About 70% of adults use the solution.

Similarly, mobile e-commerce in Asia has leapfrogged that in Europe and the US, with 45.6% of consumers having made a purchase using their smartphone, according to MasterCard. By comparison, fewer than 30% of UK consumers have bought something using a smartphone, according to coupon marketplace RetailMeNot. Research by McKinsey shows that Chinese e-tailing is boosting the economy by stimulating purchases that consumers would not otherwise make.


For Ashmore’s Dehn, the current panic about emerging markets reflects a failure on the part of analysts and investors to distinguish between financial markets and economic fundamentals. “Apart from Argentina and Ukraine, which are a case apart, there have been no sovereign defaults, no significant increases in corporate defaults, no runs on FX reserves and no balance-of-payments crises,” he says. “Emerging markets continue to hold 80% of the world’s FX reserves—which have fallen just 7% from their peak despite a 40% decline in the US dollar (in which reserves are denominated)—while these countries have just a third of the government debt of developed markets.”

Dehn says that most emerging markets countries have maintained a tight leash on inflation, so their currencies’ devaluation against the dollar is helping to enhance their competitiveness: Ninety percent of the emerging markets countries Ashmore tracks have enjoyed improvements to their current account. “Moreover, the terms of trade have improved for two-thirds of emerging markets counties because the price of oil has fallen faster than that of other commodities,” says Dehn. “Ultimately, the emerging markets story remains sturdy. All that’s occurred to date is a small slowdown in growth.”