Emerging Markets: Issues In Investing

Risk Aversion: Key To Global Asset Allocation

In an environment dominated by economic uncertainty, lack of confidence in audited corporate accounts, investment analysts’ recommendations and credit rating agencies, problems with the insurance industry’s solvency ratios, weakened bank balance sheets and pension fund deficits, on-going crises in the Middle East, pessimistic business sentiment surveys, restrained global trading and capital spending, decline in consumer confidence and spending, rise in public and private sector debt, along with an unsustainably high US current account deficit, higher price of oil – to list a few of the variables in any serious investor’s risk matrix – it is not surprising that the case for investing in Emerging Markets (EM) becomes more complicated than usual.

The rebalancing of global portfolios as a result of this risk aversion sparked massive declines in equity markets in 2002. Consistent with this conservative global asset reallocation, investors reassessed investments in those EM where economic reform was threatened by domestic political uncertainty, as was the case in many Latin American countries as well as other countries such as Turkey. Elections in Brazil, South Korea and to a smaller extent in Kenya overshadowed developments in these markets as well. In terms of composition, capital flows to EM in 2002 were dominated by direct investment, though such flows declined from the previous year as the pace of structural reform and privatisation slowed.

Against this background, net private capital flows to EM according to estimates provided by The Institute of International Finance (IIF) are to rise modestly in 2003 to about $137 billion from $113 billion last year as global economic recovery begins to pick up in the second half of the year. Despite the anticipated increase, this year’s capital flow will be significantly below the average of $185 billion over the past decade. This year’s projected increase reflects the‘cessation of private capital outflows from crisis countries’ that occurred in 2001 and 2002 rather than an improvement in inflows into EM. A major risk for EM in 2003 is that the global economy does not recover sufficient momentum during the year. With the economic outlook remaining anaemic in Japan and Europe, in the event of a retrenchment in G7 growth, exports from EM and capital flows to EM are likely to suffer.

For some EM, there is scant evidence that capital flows will revive as the scope of investment opportunities has widened and foreign investors are more discriminating in their search for risk-adjusted returns. Global equity under-valuation, extreme risk aversion, unusually short investment time horizons and rising levels of liquidity characterise the professional investment community today. Although structural reform and privatisation continue in a number of EM, the momentum has slowed. Last year’s volatility in Latin America, combined with disregard for investor rights as well as ongoing debate on approaches to the restructuring of unsustainable sovereign debt, has increased perceived long-term risks to investing in EM. Thus, capital flows to EM are likely to remain subdued until global investors become more willing to take on more risk and uncertainties surrounding policy continuity in key EM are removed.

The move by one of the largest and most powerful public pension fund in the US, CALPERS, to stand by its controversial decision to invest only in those EM that meet the fund’s stringent ethical and financial standards, means that the fund does not invest in some of the leading EM such as China, India, Russia and Indonesia among others. According to CALPERS, its board members were not in favour of its socially responsible investing (SRI) policy simply for political reasons. They firmly believe political instability, lack of transparency and market liquidity are inherent investment risks and impact the bottom line. Although EM comprise less than 1% of the CALPERS portfolio, the example set by such a high-profile fund may lead other investors in the US with SRI concerns to follow suit.

For Richard Chenevix-Trench of Sloane Robinson Investment Management, based in the UK, there is a fundamental issue when investing in EM:‘The higher living standards and income in emerging markets have been procured at very high cost – in terms of higher corruption, dysfunctional societies, lack of democratic institutions and robust legal structures. Investors have woken up to the fact that huge tracts of the world have advanced marginally, but used vast resources to achieve that.’ However, the performance of his EM fund, which delivered a net return of 20 percent in 2001 and 4.5 percent in 2002, is clear evidence of the investment opportunities available in these difficult markets. For Chenevix-Trench:‘Emerging markets are a relatively good place to be. Valuations are compelling. However, predicting the spark that will trigger a realisation of that potential value is more difficult in the current investment environment dominated by risk aversion.’

The March 2003 Merrill Lynch Global Fund Manager Survey of over 300 fund managers responsible for $732 billion found that fund managers took a much more cautious line on the outlook for the real economy, commodity prices, nominal GDP growth and EPS growth. However, just over half the panel believes equities to be undervalued, and almost 30% of the panel believe equities in general to be undervalued by 15% or more. At the same time, the level of risk aversion continues to rise: a record 47% of those polled admitted to taking a lower-than-normal level of risk in their investment strategy. Global fund managers continue to find EM attractive in terms of valuation. They also think that the outlook for corporate profits within EM to be ‘most favourable,’ closely followed by the US. But, they are less convinced about the ‘quality of earnings’ in EM in terms of volatility, predictability and transparency.

While leading investors are of the view that the global economy would not be allowed to head for macro-economic deflation, thanks to concerted government intervention, there is also the knowledge that long term returns from developed markets are going to be low, due to the weak prospect for earnings’ recovery. While the appropriate level of the equity risk premium (ERP) remains an issue among academics as much as practitioners, research suggests that some 70 percent of fund managers assume an ERP of 4-5 percent, which coupled with low earnings’ expectation translates to low returns. Also, risk has shifted from equity to bond markets in developed countries as governments relaxed their fiscal policies and were more prepared in the interest of global financial stability to underwrite some of the risks previously borne by the private sector.

The confluence of these factors encouraged some investors to over-weight EM in a global portfolio. According to Michael Hughes, Chief Investment Officer at Baring Asset Management (BAM), which has a long history of investing in EM, BAM in preparing for an era of low returns in developed markets, favours its‘higher alpha emerging market and Asian funds, where risks have reduced.’ Given the onset of a lower return environment, investors are best served by taking on more risk in markets with out-performance potential; the key point being that EM out-performance was likely to continue as‘the risks attached to emerging markets have reduced to converge with higher risks attached to developed economies.’

It is worth noting that these risks include stock specific risk as well as market risk emanating from macro-economic, exchange rate, political, regulatory and operational risk issues among others. While many EM, since the meltdown in 1997/98, made progress in the management of these risks, cracks have appeared in the management of risks in several developed countries, thereby reducing the perceived risk disparity between them. As structural reform stalled in the Euro zone and Japan, and the accounting scandals and issues surrounding analysts’ independence erupted in the US, not to mention 11th September 2001 which made the US seem just as vulnerable as any other EM in the world, weaknesses in developed countries’ management could no longer be glossed over by investors.

Such views are held not only by EM fund managers, but also by global fund managers whose decisions have an important bearing on asset allocations. The great risk divide between emerging and developed markets has shrunk. Even in terms of operational risk, according to Thomas Murray, the rating and information services consultancy, ‘an emerging market is no longer defined in terms of location or economics.’ For Derek Duggan, a director of Thomas Murray in London:‘Some countries that might obviously fall into this category produce some surprising results; for instance, all the Baltic countries rank higher than Japan (the lowest ranked developed market). Latvia, the top Baltic country outperforms its oil rich neighbour Norway despite the latter’s AAA sovereign rating (an important component in the rankings).’

Prospects for Emerging Markets

With recovery in industrial production not just in Asia (excluding Hong Kong), but now showing albeit less strongly in Latin America (excluding Venezuela), improvements in trade and current account balances as well as in foreign exchange reserves (Mexico, for example, reported in February its first monthly trade surplus since mid-1997), the general consensus among investors is that EM equity, as an asset class, represents good value. Also, with portfolio inflows remaining subdued, EM markets have not undergone the sort of re-rating witnessed in 1990s.

Valuation Comparisons World EAFE N America EM Free
Price Earning 22.11 24.45 20.78 12.7
Price to cash earnings 9.89 8.14 11.46 7.01
Price to book value 2.01 1.51 2.59 1.33
Yield 2.45 3.18 1.96 2.99
As at 31 March 2003. Source: Morgan Stanley Capital International

In the Genesis Emerging Markets Fund’s (Genesis Investment Management is a London-based firm dedicated to investing in EM) thirteenth Annual Report to Shareholders for the year ending June 2002, the Chairman, Mr Jeremy Paulson-Ellis, identified three significant reasons to be optimistic about EM at the corporate level. They include:

  • Valuations both absolute and relative to major markets are compelling;
  • Returns on equity at the better-run emerging markets companies are rising fast, as costs have been cut, low return businesses eliminated, balance sheets re-structured, capital better allocated, and corporate governance improved;
  • Demographics, where huge increases in the productive age groups in this decade and beyond will sustain developing countries’ comparative advantage in manufacturing (and increasingly in services), and provide millions of extra consumers to drive domestic economies.

These positive factors continue to support the case for EM. Emery R. Brewer, manager of Driehaus Emerging Markets Growth Fund, is similarly optimistic:‘A lot of the economies in the emerging markets have already gone through a period of crisis followed by a period of restructuring. For these companies to survive, we saw a lot of selling of non-core assets, paying down of debt and de-leveraging and they also became a lot more transparent.’ In the most successful cases restructuring filtered down to the economy, boosting consumer confidence, lowering interest rates and boosting domestic markets. The pent-up domestic demand buttressed these economies against the slowdown in developed markets. The strong rebound in returns in EM in the final quarter of 2001 and the first quarter of 2002 was in recognition of better fundamentals. However, as the prospect for international financial markets worsened, particularly in the US, capital flows to EM started deteriorating from mid-2002. But the retrenchment was not specific to EM as an asset class; it was distributed across all high-risk assets.

Favourable commodity prices, better operational risk management, corporate governance and responsible fiscal policymaking created a foundation for better times ahead as the private equity bubble in the US began to collapse in 2000. The credit fundamentals of many EM economies improved with real improvements in inflation accompanied by massive improvements in budget balances. Trade deficits for the most part were under control and economic growth was firm. Due to the already depressed state of EM, the contagion effect was also muted. Crisis in various markets enabled a new generation of managers to emerge. For David Jones, President and CEO of Delta Capital Management, a major investor in Russia:‘Russia’s new generation of entrepreneurs and managers lead the country’s migration to transparency, proper governance and best practices. Our mission is to identify these young leaders and to recruit and develop them for our common goal of successful company building.’

2003 certainly poses challenges for all investors. But, EM investors remain optimistic about the earnings multiples and price-to-book values in EM that are at the low end of their historical range. They are cheaper than stocks in the developed world despite the sizeable falls on the developed exchanges. The differences between EM and their developed counterparts are at their most significant when it comes to growth. While growth has been paltry in the low single digits and looks likely to remain so in developed economies, many EM have grown significantly faster, with Asia growing 6% on average for the last four years. China’s attraction to multinationals has generated strong FDI into the mainland. The UN expects China to overtake the US as the largest recipient of FDI in the world. While it is reasonable to expect Asian exports to slowdown over the coming year in response to weaker overseas demand, domestic demand in many economies remains strong, supported by consumer rather than fiscal spending. The modest fiscal balances add further cushion should growth start to falter. This fortunate configuration should continue to support corporate earnings growth and valuation of EM equities.

However, average exposure to EM by relatively sophisticated institutional investors in the UK, for example, has remained at 1 percent or less, a figure that does not reflect trends in global trade or growth, over the past several years. According to Russell/Mellon Combined Actuarial Performance Services Limited, discretionary portfolio asset distributions (weighted averages) in balanced funds to 31 December 2002 consisted of 78.7% in global equities, of which 52.6% was held in the UK, 26.1% in overseas markets, which in turn had 11.5% in Europe (ex UK), 6.0% in the US, 3.4% in Japan, 4.2% in Pacific ex Japan and 1.0% in Emerging Markets. It is worth noting that investors in the WM All Funds Universe, representing 75% of the UK segregated pension fund industry with total assets valued at £343 billion on 31 December 2002, had a higher allocation to EM. Their asset distribution consisted of 64.4% in global equities, of which 39.4% was held in the UK, 25% in overseas markets, which in turn had 8.6% in Europe (ex UK), 7.0% in the US, 3.6% in Japan, 3.2% in Pacific ex Japan and 2.5% in Other International or Emerging Markets. This allocation is still below the 3.9% weighting that the EM Free Index currently holds in the MSCI World Index Free.

For Brad Durham, managing director of EmergingPortfolio.com Fund Research (EPFR) based in the US which collects fund flows and allocations data on more than 3,000 EM and international funds with more than $700 billion in assets:‘After gaining 8.4% year to date and about 22% in the current rally that has lasted for six months, EM debt may be vulnerable to some profit taking. But investors still keep pumping money into these funds even as war uncertainty gets drained from the market and equities begin to look attractive. Bond fund managers generally remain constructive due to the solid internal fundamentals in most EM economies. Global EM equity funds attracted net investor inflows in two of the last three weeks.’ Among the regional equity funds, flows have been strongest into Asia ex-Japan. In 2003, ‘EM portfolio managers have shown a strong appetite for Asian equities, with China, Hong Kong and India receiving significant net buying in the first two months of the year,’ according to new data released by EPFR.‘Select South African companies benefiting from rising commodity prices have also been on their shopping list while fund managers sell Mexico, Taiwan and Russian equities’ adds Brad Durham.

Data provided by the Institute of International Finance, Inc. confirms that net private capital flows to EM in 2002 and for this year have fallen to about the same level as in the early 1990s, and well below the average over the past decade. As real GDP has grown, net private capital flows as a share of GDP, have declined from 4 percent in 1992 to just over 2 percent projected in 2002. The shift towards direct investment indicates greater stability in long-term capital flows. The fall in portfolio investments, on the other hand, reflects greater pessimism among global equity investors. On balance, the rise in private capital flows reflects major reforms in EM. Debt service as a share of exports, for example, has fallen from 63 percent in 1982 to 30 percent in 1992. Average inflation fell from 56 percent in 1985 to 29 percent in 1995 and 9 percent in 2001. As initial exuberance has given way to more realistic expectations, net private capital inflows to EM declined in real terms.

Emerging Markets’ External Private Financing (In billions of US dollars; all figures are net)
Year Direct Investment Portfolio Investment Private Credit Total Private Capital Inflows
1991 23.4 5.0 45.6 74.1
1992 31.1 15.8 77.0 124.0
1993 44.4 51.9 92.6 188.9
1994 65.4 34.4 74.4 174.1
1995 75.3 28.8 128.8 232.9
1996 92.3 35.3 207.4 335.0
1997 116.2 25.1 124.3 265.6
1998 121.0 12.2 9.8 142.9
1999 149.1 15.0 -15.9 148.2
2000 135.6 14.3 35.7 185.6
2001 134.3 10.2 -18.8 125.7
2002e 106.6 -4.7 10.5 112.5
2003f 107.7 8.9 20.5 137.1
e = estimate; f = IIF forecast. Source: Institute of International Finance, Inc.

Direct investment flows to EM have also been affected by the sharp drop in global M&A activity which is related more to the general increase in financial market uncertainty and global economic slowdown than to specific concerns about EM. Thus, private equity flows to EM have been rather weak. In terms of portfolio investments, higher correlation between equity markets has weakened the diversification argument in favour of EM, despite the higher risk premium attached to the asset class. While investors are increasingly distinguishing among EM countries in terms of risk, the overall appetite for risk has waned. Also, increased volatility in developed markets means that risk management is more challenging. When one adds to that the perceived higher operational risk of investing in EM, it is easy to see why the case for significantly higher allocation to the asset class gets complicated in large global portfolios. In a technologically advanced era, investing is also driven by quantitative factors; risk managers worry more about quantifiable risks than those they cannot calculate. Trustees and plan sponsors are increasingly more aware of their fiduciary responsibilities and conscious of risk-adjusted returns.

How Important Is Operational Risk In Emerging Markets?

When asked:‘How important is operational risk to you when investing in emerging markets?’ the answer provided by the majority of global investors suggests that it is not a significant issue for them, but more for their global custodians. The ability to settle securities transactions efficiently in any market is taken for granted by fund managers. Understandably, the superior ability to settle in any market is considered the sine qua non of the global custody business. Most investors agree that operational risk is the last major component of total risk. Both investors and regulators would dearly like a metric to measure and monitor this risk but so far this has proved elusive.

The Thomas Murray EM custody and settlement infrastructure risk rankings measure the exposure to post trade settlement risk that cannot be contracted away by an intermediary such as a global custodian. As well as including a component for sovereign risk, the metric also includes components for clearing & settlement, safekeeping and asset servicing.‘When judging how safe a portfolio is, the investment adviser needs to consider the exposure to the settlement process (risky, but usually only an exposure during the settlement period, typically T+3) and the exposure to holding assets in that country (less risky but the exposure is open ended). While the Thomas Murray methodology takes into account operational risk at the market infrastructure level there are other components throughout the value chain that are not included in the risk rankings: e.g. risk at the domestic custodian, global custodian and broker,’ confirms Derek Duggan of Thomas Murray.

Between 1996, the peak of portfolio investment inflows into EM, and 2002 by which time portfolio investments declined to levels last seen a decade ago in 1992 when many of these markets were not open to foreign investors, substantial changes in legislation, the regulatory framework and accompanying investments were made by both EM countries and global custodians in their combined effort to attract foreign capital by improving the domestic market infrastructure. In the opinion of Robert Kay, managing director of Global Securities Consulting Services:‘Emerging markets have coped effectively with recent changes in the volume of activity. Given limited liquidity and falling volumes of trade, global custodians and domestic operators have done a relatively good job in upgrading their market infrastructure and regulatory practices. However, with ongoing decline in the volume of trade, will global custodians begin to question their comprehensive coverage of emerging markets, particularly as the numbers of markets keep growing?’

Bearish market conditions have not reduced the volume of transactions in the major equity markets. If anything, both the number of transactions and the volumes has gone up significantly in these markets. But, it has not impacted on the percentage of trades settling on the contractual date. Activity in EM on the other hand has yet to recover to its mid-1990s peak, when operational risk issues were high on the list of fund managers in their quest for higher returns. While progress has been made in several EM markets, trading volumes has not yet tested the capacity of these markets to deliver. According to Global Securities Consulting Services (GSCS) Benchmark, the average settlement rate in the various EM monitored by the firm rose from 73 percent in December 1995 to 94 percent in June 2002, while the average number of transactions per month rose over 2.6 times over that period. It is clear that the presence of foreign investors in developing markets helped in bringing about changes. Domestic investors in EM never had the choice or the influence to demand improvements in market infrastructure before they committed their capital. For foreign institutional investors, on the other hand, markets do not appear on their investment radars unless certain conditions were prevalent.

As James P. Donovan, Regional Business Executive for Europe, Japan, Middle
East and Africa and part of Citibank's Global Securities Services division, says:‘There exists a high degree of co-relation between market infrastructure and economic development in EM. Portfolio investment has suffered
in countries that failed to keep pace with international best practice by aiming to improve their regulatory standards. Markets that failed to implement fair and equitable policies, and are not supported by attractive infrastructure, have seen some reversal of fund flows. Thus, those markets keen to attract foreign investment have also invested in improving their infrastructure, both market and non-market.’

The advantage for some EM countries with recent low volumes is that they have been able to introduce modern sophisticated systems with no legacy issues, which is a major burden for many of the more developed countries. For Derek Duggan:‘While there is no regional pattern apparent, a number of countries made an effort to reduce operational risk, and are to be commended for that.’ He identifies some markets for special commendation – they include Brazil, with its recent introduction of real time gross settlement (RTGS) cash payment system; Hungary, which also ranks ahead of Japan but more importantly is also rated above its local rival Poland, although Poland is pushing its market very hard with numerous good developments such as stock lending & borrowing, RTGS settlement, additional settlement cycles etc.; India, which has gone from account period settlement to T+5 then T+3 at an amazing pace; Egypt for pushing through many developments such as T+2 settlement, tougher capital requirements, margin trading, etc., which have been negated by a sovereign downgrade and a freeze on capital repatriation; Philippines, for its immobilisation of equities and dematerialisation of bonds and Indonesia and Thailand for introducing real time payments systems.

"While genuine emerging market countries will be held back by poor sovereign ratings, we would like to see improvements in central Africa and Russia (the latter is possible with the recent introduction of legislation to constitute a central securities depository),’ adds Thomas Murray’s Duggan. Operational risks are related mainly to non-standard manual processes in the market, and are exacerbated in a physical environment. India is a good example of a market that removed significant operational risks by migrating from a physical environment to an almost fully dematerialised market, thereby eliminating issues such as bad deliveries, fraudulent shares, long periods of illiquidity and high settlement costs. South Africa is another example where operational issues have been addressed by a similar move to a dematerialised environment.

Investment in market infrastructure has had positive results in most active EM. However, with low trading volumes even the most dedicated custodian would have found it difficult to enlist the support of local authorities in enhancing their market infrastructure further. According to the Global Custodian 2002 survey, ‘operational risk and disaster recovery’ did not rate highly among either fund managers or custodians. Fund managers rated the automation of existing workflows/ processes, reduction of transaction costs and the transaction processing capacity/ scalability ahead of operational risk issues. Thus, operational risk issues no longer appear to be a major concern when investing in EM.

According to Richard Chenevix-Trench of Sloane Robinson Investment Management:‘Operational risk is not so high in most places, provided you stick to what foreigners are allowed to do. Operational risk increases mightily when foreign investors think they can stay within the letter of the law and yet avoid the spirit of the legislation. The biggest risk is one of arbitrary change in administrational or fiscal matters. The latter is particularly worrying where authorities permit operations and then suddenly question whether they wish to continue to do so. This most often affects tax issues such as capital gains tax (CGT) and other withholding taxes.’

As the number of markets within the EM asset class has been rising, global custodians are faced with the dilemma of investing in these new markets’ infrastructure with scant trade volumes to justify such spending. Understandably, the more established and better-regulated markets within the sector have an edge as far as attracting portfolio investment is concerned. The superior returns these markets offer continue to attract investors with a higher risk tolerance. However, allocations to EM in global portfolios remain insignificant, even when fund managers prefer the asset class. The inability to trade in large volumes, for example, has historically been cited as a reason for not making higher allocations to EM. While the market infrastructure may have improved, the low volumes of trade do not inspire confidence among fund managers.

Liquidity, Liquidity, Liquidity

Efficient trade execution is a top priority for all market participants. However, institutional investors are also concerned about liquidity, or the ability to trade large blocks of stock without moving the price. Predictably, there is a strong correlation between market size, turnover and price impact. One of the major impacts of globalisation on EM was the rise of the depository receipt market. Since 1992, EM companies have been actively raising capital in developed markets. In fact, the bulk of the fund-raising by EM companies in the second half of the 1990s was in international markets. Often trade in overseas instruments eclipsed the trade in the underlying stock in the domestic market.
Increased transparency and better execution are also good reasons for buying American Depository Receipts (ADRs). Investors prefer the stricter corporate governance and disclosure requirements in the markets where the majority of ADRs and Global Depositary Receipts (GDRs) are listed. Although the spate of corporate scandals in the past year has involved mostly US companies, regulatory standards on Wall Street and London are generally perceived to be higher than in other markets. The tougher listing requirements often result in greater liquidity for the ADR than in the primary listing. Lower clearing costs and the ability to trade during local market hours can also tilt the balance in favour of ADRs and GDRs for American and European investors alike.

Depository receipts account for some 10 percent of mutual fund equity holdings in the US; these numbers could be significantly higher for dedicated EM funds. The convertibility between domestic stock and ADRs has put pressure on EM policymakers to improve their domestic market infrastructure. Operational risk considerations traditionally encouraged fund managers to invest in ADRs/ GDRs and other such instruments listed in developed markets. Local companies were better able to secure a higher rating even as they reduced their risk premium. Technology companies from Israel, India, Asia, Latin America were major beneficiaries during the technology, media and telecommunications boom years. Many South African companies also took advantage of this trend by issuing ADRs in the UK market. In 2002, Asian companies were the most active in issuing ADRs, with China Telecom’s IPO being among the largest in the sector. According to the Institute of International Finance, ‘total equity placements were only $6.7 billion in 2002, compared to the peak of $28.5 billion in 2000; nearly a third of these flows were to China which sold a few of its large public enterprises.’ Of the ADR programmes in the pipeline with Bank of New York, about 50% are from Asia. However, equity issuance is unlikely to reach the levels seen in 2000 for quite some time as most of the easy privatisation sales have already been completed and market appetite for new issuance is weak.

Ongoing structural reform encouraged privatisations and the easing of restrictions on foreign investments facilitated a rise in direct foreign ownership. The resulting takeover of EM companies by companies in developed countries was another example of rising globalisation in some sectors, leading to companies in the oil, banking and telecom sectors seizing the opportunity to maximize their company’s valuations. While takeovers were good for shareholders, it had a devastating effect on the liquidity and overall development of the local market. As liquidity dried up, price determination was driven offshore. Policymakers were rightly concerned. Though some responded favourably by bringing in more investor friendly practices, others turned hostile towards foreign investors thereby choking off the growth of the domestic markets. Change in domicile or listing also created problems in company definition. As domicile or listing moved overseas, they were no longer eligible for inclusion in the major EM indexes. Even if companies were to be defined by their earnings profile or by the country from which their largest share of earnings is derived, the EM companies that were taken over simply disappeared in the giant revenue streams of the multinational companies that acquired them.

"The number of companies one can invest in has been shrinking as a result,’ confirms Richard Chenevix-Trench, an experienced investor in EM. For any fund manager, liquidity is fundamental to stock selection. Thin trading volumes and lower prices in EM exchanges clearly indicate the absence of significant international investment. Domestic investment activity has also been muted as several EM have been recovering from major crises. Lack of liquidity in the shares of closed-end funds with the persistence of wide discounts to NAV at which the shares tend to trade has not helped investor confidence either. The high-profile disagreement between Harvard Management Company (HMC) and Templeton Investment Management is a case in point. In a filing with the Securities & Exchange Commission, HMC stated:‘with an adviser committed to achieving maximum shareholder value, shareholders will be more likely to realise the true value of their investment.’ Realising the true value of an investments over a given time horizon can turn into a major issue for EM investors.

Performance of Emerging Markets

Prospects for EM worsened in mid-2002 as weakness in the global economy resurfaced and political and economic uncertainty in various EM climbed. Until the situation in Iraq is under control, the uncertainty surrounding developments in the Middle East and its impact on the prospects for global growth does not augur well for markets in general. The negative impact of a rise in the price of oil on emerging economies has now been well recognised by investors. Although the real impact would continue to be cushioned by the intervention of the monetary authorities around the world, many EM economies would be far worse affected than the OECD oil importers. Higher oil prices are already worsening South Korea’s trade balance and boosting inflation. And countries such as India, highly dependent on oil imports, may also find it difficult if the price of oil does not fall, although India is cushioned by its relatively high foreign exchange reserves.

During the last Middle East conflict in 1991, when the US was in recession, EM began a benign upward cycle of economic and stock market growth. It is not clear that history is on the verge of repeating itself, although a short-lived rally in EM equities cannot be ruled out. Rising unemployment in the US is an issue. The run of job losses has added to speculation about the economy’s travails. Employment generally lags recovery in demand, and job losses have given way to robust expansions in the past. However, the job losses in this recovery have surpassed, in size and duration, those of previous post-recession periods, including the ‘jobless recovery’ after the 1990-91 recession. Having experienced serial turmoil in their markets, be it the Tequila crisis of 1994, the Asian crisis of 1997, the Russian crisis of 1998, or the ones in Argentina, and Turkey in 2002, EM investors have undergone a baptismal by fire over the past decade. The full cycle of asset inflation and destruction during the 1990s for EM investors was an invaluable lesson. Portfolio assets moved out of EM steadily since 1996, and a reversal was not seen until the final quarter of 2001 when investors sought to reduce their exposure to the US market. Even with the bursting of the bubble in the US, assets are now priced more competitively in EM markets.

Global Performance Comparisons 1 yr 3yrs 5yrs 10yrs
Emerging Markets (Free) -22.43 -18.32 -8.99 -1.94
North America -25.89 -18.23 -5.34 6.51
EAFE -24.74 -20.89 -8.56 0.40
World -25.30 -19.45 -6.85 3.37
As at 31 March 2003. All figures are in percentage terms, annualised, in US $. Source: Morgan Stanley Capital International /td>

With improvements in the macroeconomic management in most EM countries, investors in EM debt have outperformed most others. Over the past decade, EM debt has delivered better returns than many other asset classes. Annual average returns in EM debt markets in dollar terms from 1994 to the end of 2002 were 10.3%, compared with a 6.6% decline in EM equity. The S&P 500 return over that period was 7.3%. Emerging bond markets have been growing faster than other bond markets, but so far they represent less than 10% of the global market. Although foreign investors have tended to focus on foreign currency external debt issued by EM, the size of the local bond markets is at least several times as large. The attractiveness of EM dollar-denominated bonds is clear; local currency risk is an additional burden for managers to monitor. With decline in volatility, the emerging bond market has evolved into a large, liquid and respectable asset class. The total size of the market is estimated at over $2,000 billion, more than twice the size of the high-yield corporate debt market. The growth of bond markets in EM is a major development and augurs well for the future of that asset class.
As a result, the share of high-quality, long-term investors such as pension funds and insurance companies has risen from less than a tenth to about a third since 1997, while the share of hedge funds has gone in the other direction from about a third to a tenth. The lack of contagion from Argentina and Brazil was partly the result of these structural changes in the EM investor base. The reason for this shift is also reflected in the lower yields from such investments. Gone are the days when Russian 30-year bonds yielded 70% (in 1998) or even 27% (in 1999) that proved so attractive to hedge funds. Yields look fairly pedestrian now at 8-9%, a mere 3-4% above US Treasuries that is highly valued by more staid investors such as pension funds. While EM are safer than they were a decade ago, they are far from being crisis-proof; a country could still default or get downgraded. While bonds and fixed interest investments in EM have performed well, the primacy of country allocation when investing in this asset class cannot be ignored. A country defaulting on its debt, a collapsing currency or a military coup affects both bonds and equities. Company earnings suffer along with the credit rating of the country.

The high level of non-correlation among EM constituents themselves means that a higher level of investment skill is rewarded, although the lack of it can also be punished. Country factors still account for 75 percent of the performance of EM. While sector influence on markets has gone up, for investors getting the asset allocation right is of utmost importance and rightly so as taking a closet-index approach to investing in this asset class can only result in poor performance. Individual markets within the sector are highly non-correlated. Investors could lose all the money made in one region or market by investing unwisely in the region or in other markets that fail to deliver. As there are too many markets involved, the chances of getting them all right are minimal. On the contrary, chances of getting markets wrong even by experienced investors can be high. The obvious challenge of investing in emerging markets is that of asset allocation as the number of markets keep increasing within the asset class.

Performance Comparison Within Emerging Markets 1 yr 3yrs 5yrs 10yrs
EMF Asia -25.94 -21.21 -8.38 -5.36
EMF Latin America -30.33 -17.41 -10.84 0.36
EM Europe & Middle East -10.30 -18.13 -5.71 4.16
EM Europe -9.83 -17.19 -5.99 4.32
EM Eastern Europe -2.50 -7.06 -6.19 NA
Emerging Markets (Free) -22.43 -18.32 -8.99 -1.94
As at 31 March 2003. All figures are in percentage terms, annualised, in US $. Source: Morgan Stanley Capital International

Considering we live in a world where the total amount of debt in Japan, the US and in most of Europe is significantly high as a percentage of GDP, the debt burden of EM countries looks more manageable. Besides, the private debt ratios are higher than the public debt ratios in the developed world. To cope with this problem, we have moved into a period of fiscal and monetary stimulus, thereby generating public deficits. The move to lower real interest rates is also one way of getting growth going and providing the conditions for private debt ratios to be reduced. If interest rates are lower than economic growth, then the debt will not rise by the cost of servicing it. But these strategies appear not to be working because these debt ratios have not come down. We have clearly moved to an environment, which sees debt ratios being reduced by transferring the responsibility for them from the private sector to the public sector. While debt ratios in EM are lower, looking ahead risks to the international financial market stability continues to emanate from developed markets.

The withdrawal of funds from mature markets translated to a major negative impact on EM, which remains susceptible to a higher level of risk aversion and the lack of global liquidity. Regardless of their cyclical nature and the structural problems inherent in EM, the reality is that in an uncertain global environment, the appetite for risk declines sharply. Figures from the UN Conference on Trade and Development, for example, confirmed that the level of foreign direct investment (FDI) more than halved in 2001, falling to $735 billion worldwide, with the largest declines seen in the industrial nations. However, FDI flows into EM remained strong; China attracted nearly $50 billion of FDI compared with $125 billion for the US. On average, FDI into EM has kept growing over the past decade; the same cannot be said of portfolio investments in either equity or bonds. The importance of FDI by multinationals in EM can be gauged by their share in exports from a wide range of developing countries, such as Hungary (80%), Poland (56%), China (50%), Malaysia (45%) and Mexico (31%) among others.

Looking ahead, there are several factors that will influence the performance of EM. For a start, any improvement in capital flows to EM rests on expectations of continued global recovery. A rise in inflation and a concurrent rise in interest rates globally would impact negatively on EM, although in the long-term many EM would benefit from a higher level of inflation through debt reduction. The cost of capital remains high in EM and poor management often results in ineffective cost control leading to poor return on capital. For some EM, this may not be the case. However, the nascent stock markets in Africa and the Middle East have been in the doldrums and have seen little inflow of investment through their exchanges. Africa is also the region in most need of debt relief. While the war in Iraq clouds the picture somewhat, according to the IIF, net private flows to Africa/Middle East are likely to double in 2003, rising from around $4 billion in 2002. This rise reflects an expected recovery in private flows to South Africa as a result of the anticipated privatisation of Telkom, and a pickup in non-resident purchases of equities and fixed income securities. The same cannot be said of portfolio investments which peaked at $4.7 billion in 1999.

Portfolio Investment By Region In Emerging Markets (In billions of US dollars; all figures are net)
Year Eastern Europe Asia/Pacific Latin America Africa/Middle-East Total
1990 14.0 0.7 2.5 -0.6 16.6
1991 12.3 -0.3 7.0 -1.7 17.3
1992 14.9 7.9 8.5 -0.1 31.2
1993 6.3 25.2 20.8 0.9 53.2
1994 2.1 16.2 13.9 0.3 32.5
1995 -0.3 15.2 6.0 2.6 23.5
1996 2.8 20.4 11.1 1.0 35.3
1997 3.2 6.8 11.8 3.2 25.0
1998 3.9 4.0 0.8 3.5 12.2
1999 -0.3 18.1 -7.6 4.7 14.9
2000 -2.4 21.2 -6.2 1.7 14.3
2001 1.6 13.0 0.7 -5.1 10.2
2002e -0.7 -1.9 -1.8 -0.3 -4.7
2003f 1.2 5.3 -0.4 2.1 8.2
Total 58.6 151.8 67.1 12.2 289.7
e = estimate; f = IIF forecast. Source: Institute of International Finance

At the other end of the spectrum, for the former colonies of Russia such as Hungary, Czech Republic and Poland, ‘convergence’ is the key. Several emerging economies in Europe are aiming to join the Euro zone in 2004. The countries set to join are Cyprus, the Czech Republic, Estonia, Hungary, Latvia, Lithuania, Malta, Poland, Slovakia and Slovenia. The expected loosening of monetary policy in these countries will stimulate growth, as interest rates fall from current levels to that in the Euro area. Furthermore, household lending, currently a fraction of levels in the West, is predicted to explode. These factors could stimulate economic growth of 4-5 percent, several times that of Germany and other major European economies. It is true, the EM in Europe remain a geared play on the European union. If economic growth is muted in Europe, the reward for joining the club may not be experienced in the short term.

Following declines of output over the past couple of years, Latin America is now experiencing a moderate recovery. Policies are improving in several countries along with signs of stronger growth. Governments in a number of these countries are currently engaged in implementing reforms that could – if reforms are sustained and the external environment improves – generate the beginning of a virtuous circle of fiscal improvement, lower interest rates and higher growth. While the balance of evidence looks favourable, there are significant downside risks. The Asia Pacific region has attracted the bulk of portfolio investments since 1993, with the exception of 1997. If the outlook for the US economy improves, there is always the possibility that global investments will flow back into the US, as institutional investors remain underweight in that asset class. However, there is general consensus that EM equities are under-valued and have potential for out-performing other equities. They are an option on global recovery, particularly in the US.

Shanta Acharya began her investment management career with Morgan Stanley Asset Management in London after an academic career at Oxford and Harvard. She subsequently worked as a fund manager for Swiss Bank Corporation Portfolio Management International and Baring Asset Management. Her most recent publication is Asset Management: Equities Demystified (Wiley, 2002). She is also the author of Investing in India (Macmillan, 1998).