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Fri Feb 24 11:55:10 PST 2006

This time, emerging markets are for real

HERE is an arresting little flake from this week¹s blizzard of news: Hugo
Chávez‹president of Venezuela, self-styled leader of the Bolívarian populist
revolution, scourge of American imperialism and its capitalist lackeys‹is
about to start repaying those lackeys debts that have their roots in the
Latin American debt crisis of the early 1980s. Venezuela has just announced
that it will retire almost $4 billion of ³Brady bonds². These securities,
named in 1989 after Nicholas Brady, then America¹s Treasury Secretary, were
the instruments by which Latin American governments repackaged tens of
billions of dollars of defaulted loans from western commercial banks flush
with petrodollars in the 1970s.

Because the bonds allowed the banks to get back at least a handful of cents
on the dollar, the Brady plan drew a line under the first emerging-market
crisis since the second world war. But because the plan also raised
emerging-market borrowers from pariah status, it helped grease the skids for
the second lot of emerging-market crises involving fresh inflows of foreign
money, notably Mexico¹s Tequila crisis of 1994, the Asian financial crisis
of 1997-98, Russia¹s default in 1998, Argentina¹s devaluation and default in
2001-02 and Brazil¹s currency woes soon after.

Venezuela¹s early repayment is a mark of how far the world has come since.
Mexico, which issued the first Brady bonds, paid its stock off in full in
2003. Last week Brazil said that it too would buy back all its remaining
$6.6 billion pile. The improvement in emerging-markets¹ reputation has been
staggering. In 2002, at the height of the Brazilian crisis, emerging-market
bonds worldwide, measured by J.P. Morgan¹s EMBI+ index, traded at yields of
more than 900 basis points (ie, nine percentage points) over equivalent
American Treasury bonds. This week, the spread dipped to a record low, under
200 basis points. The spread on Brazilian debt has shrunk, to a bit more
than 200 points, less than a tenth of what it was. Someone has made an awful
lot of money.

It is, indeed, increasingly clear that rich-world financiers are surfing a
third post-war wave of investment in emerging markets. That has already led
people to predict consequences as abrupt and as unpleasant as when the first
two hit the shore. And perhaps Egyptian debt, which changes hands at a mere
40 basis points above Treasuries, is priced rather too exquisitely for
perfection. On the other hand, the contention that emerging-market equities
offer real long-term value is a much stronger one.

Richard Cookson, a former incarnation of Buttonwood who now leads a
respectable life as global head of asset allocation at HSBC in London,
argues that private capital flows to emerging markets (both portfolio and
foreign direct investment) are still meagre, compared with the first two
investment waves. When they peaked in 1996, net private capital inflows were
equivalent to 3.5% of receiving countries¹ GDP. The figure fell to just 1.6%
of GDP in 1999 and rose to only 1.7% by 2004‹though the figure is likely to
be higher today.

Set against the great age of truly global investment in the late 19th and
early 20th centuries, which came to a shattering end with the first world
war, both the stock and flow of international investment in emerging
economies is still derisorily small, even if the stock of international
investment as a proportion of global GDP is much higher. In 1913, says
Moritz Schularick, an economic historian, 40-50% of international
investments were in countries with incomes per head less than one-third of
those in the richest economies, while nine of the top 12 recipients of
foreign capital were not industrialised countries. Today, non-OECD countries
account for less than one-sixth of the stock of international investments.
Only one economy (China¹s) among the top dozen recipients of foreign capital
qualifies as emerging.

This is of more than academic interest, Mr Cookson argues, because a secular
trend appears to be under way in which emerging economies account for a
growing share of world GDP (see chart 1). Those economies have been strong
lately, most visibly thanks to high energy and commodity prices. These
underpin both Latin America¹s resilience and Russia¹s. There has been a lot
of rich-world fretting about such high prices. But a big part of the fresh
demand for oil and commodities comes from other emerging markets, notably
China, India and much of the rest of Asia. These consumers of commodities
are growing powerfully: China at 10%, India at 7%, South-East Asia¹s big
economies at over 5%. High commodity prices, in other words, are symptomatic
of emerging-economy strength.

That strength, crucially, has been underpinned since the late 1990s by
sounder finances. Crisis and its contagion are now constrained by
current-account surpluses, where once big deficits gaped (see chart 2), and
by fat and growing foreign-exchange reserves. Plenty of concerns can be
found‹China¹s creaky banking system, India¹s chronic infrastructure and
uncomfortably high inflation‹but Mr Cookson is surely right when he says
that, on the whole, ³emerging markets are more stable than they were². And,
this Buttonwood will add, in most of them equities are far from richly
valued.

But just as any prudent investor a century ago, wishing both to boost his
returns and spread his risk, should have been deeply invested in relatively
poor countries, so he should also have withdrawn every penny before August
1914. What risks today lie in wait for the modern global investor? Political
risk is there, for sure. Indeed, in the region where this columnist sits,
few pundits, not least The Economist¹s, were predicting a week ago that by
Friday an election would be called in Thailand and a state of emergency
declared in the Philippines. Political risk?, some hardened investors will
ask in disbelief; a buying opportunity, more like.

The chief geopolitical risk, which Mr Cookson underscores, is a longer-term
one, but a process already under way: the very strength of emerging
economies is altering power relations among states. The uppitiness of Mr
Chávez, the growling of the Russian bear and even Iran¹s nuclear-tipped
ambitions have all surely been reinforced by high energy prices. Emerging
markets are producing emerging (or re-emerging) powers, notably Russia and
China. Before 1914, Britain was the superpower that policed the global
economic system. Today, the prospect is not altogether bright that the
United States, its goodwill and resources depleted by Iraq and other cares,
will play the same role. So rivalry, disputes and sometimes alarming
tensions are bound to colour this latest and most powerful emerging-market
trend.

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