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Understanding Investment Opportunities in Emerging Markets

October 23, 2017

 

So many different ideas come to mind when we hear: “emerging economies” – a term the readers of the Center for Industrial Development are well familiar with. When hearing the term some of us think about above average return on investments. Those who are risk-averse think about increased risk profile of the same investments. Others think about states with abundant resources, which – to put it mildly – have problems with well-functioning democracy. All of the above and numerous other visions of emerging economies are indeed correct. Therefore, the Royal Institute of International Affairs hosted a conference at the London Chatham House titled: Understanding Opportunity in Emerging Markets. This article aims to present insights from the event, while at the same time respecting Chatham House Rule, which does not allow us to disclose personality and affiliation of any of the participants of the event.

 

Discussion about emerging markets should start with the definition of what an emerging economy is. Fortunately, and unfortunately, there are no easy answers to this seemingly simple question. One definition states that emerging markets are economies which have had access to international financial markets for relatively short time. Some tried to define emerging markets as economies which are ready to join OECD. Others point out that it is far easier to be admitted to the club than to leave it: South Korea and Singapore are still considered emerging economies. Therefore, it is much easier to be kindly asked to leave the group due to underperforming than to leave the group thanks to good performance. Nigeria is a recent example of the former.

 

Investors present at the event have one simple objective: understanding 16 completely different economies in order to invest their clients’ money wisely. Some investors take into account three groups of factors when taking on this task. Firstly, one has to understand global macroeconomic outlooks and how they affect particular emerging economies, starting with having an opinion on how the U.S. Federal Reserve and the European Central Bank will set the interests rates, as those decisions really affect returns in emerging markets. Also having a vision on the trajectory of commodity prices is key as many of emerging economies are natural resource exporters and their ability to service debt is severely affected by commodity prices. Secondly, an investor would look at a specific emerging market with a particular focus on inflation growth, current account deficit, and interventions of the local central bank. Thirdly, an investor would look at the most critical issue for each institutional investor: liquidity of a particular bond. This is often where emerging economies start looking much less interesting for investors. However, as an increasing percentage of national debt of emerging economies is being held by the sovereign wealth funds, emerging economies start looking more appealing to investors.

 

The events at Chatham House are characterized by [brutal] honesty, which is why investors admitted that every economist who tried to predict emerging economies since 2012 got their forecasts completely wrong. There are three reasons for why is that the case. Firstly, since 2012, commodity prices have collapsed. In order to illustrate how big of a shock this drop in commodity prices was, we have to realize that in 2011 we have observed the largest boom in commodity prices in the last 200 years. Secondly, since 2012 the growth rate of global trade volumes stagnated. Once again, we have to realize that the ratio of growth of global trade volumes compared to the GDP growth in 2012 was the worst since the Second World War. Third factor, which deeply affected developments of the emerging markets is the lessening of quantitative easing policies.

 

The above are tectonic shifts for the emerging markets. However, since 2012 we have not witnessed any of the above catastrophes. In other words, we did not have the long time crisis we should have had. How is that possible?

 

Firstly, emerging economies improved their balance sheets considerably mainly through accumulation of the forex exchange in good times. Secondly, numerous countries decided to float their exchange rates which has proved to be highly beneficial in amortizing the impact of mentioned shocks. For example, Brazilian currency devaluated by 40% since 2012. In many cases emerging economies now have surpluses on their current accounts, while they had deficits before 2012. That is a great news for bankers, who love to lend money to people who do not need it therefore lowering risk. Surplus on the current account is a crisp sign for a banker to know that the given country does not really need to borrow money.

 

Emerging markets as an asset class represent 1.3 trillion USD universe, which means the market has tripled since 2010. Analysis of the emerging markets will never be complete without in-depth understanding of China, which currently accounts for 80% of the new net debt issuance of the emerging economies. China’s relationships with Africa is of particular interest for the investors, who are well aware of the potential of Africa, but had a problem with tapping into it due to variety of reasons, such as difficulty with accessing reliable data, or lack of liquidity of the African bonds.

 

In thinking about the future of Africa-China relationship one may consider a scenario in which China is the sole provider of capital to African economies and, of course, is the main beneficiary of those actions. Therefore, the Western World should look more into opportunities of providing capital to Africa, as this window of opportunity may simply close very soon. CID is happy to serve as a guide for these opportunities. It is also critical to differentiate between North Africa, with Egypt and Morocco being interesting medium-term investment markets, and Sub-Saharan Africa. Finally, there is a long-held view in developing economics which states that institutions are the key for economic development. Nelson Mandela gave a very clear example of respecting institutions by deciding not to serve as the President of South Africa longer than allowed by the constitution. Unfortunately, since then we have seen a gradual erosion of respect towards institutions in South Africa, which negatively affects the prospects of future investments.

 

The event concluded with a million-dollar hypothetical question: what would happen if Chinese growth slows down to 2% a year? The answer depends on the rapidity of such a development. Nevertheless, the ramifications of such a development would be fundamental to emerging economies. An interest rate decrease by the Fed would likely occur which would incentivize investors to look for better rates of return in emerging economies. Therefore, one can imagine a scenario in which the prices of assets in emerging economies, including China, would remain high.

 

Understanding emerging markets themselves and the opportunities they present while being intelligent about the risks present in those markets is no easy task. The international team at the Center for Industrial Development is fully aware about challenges investors face in those markets. At the same time, we are aware how many investors would like to engage more with this group of countries. Therefore, we relentlessly focus on gaining first-hand intelligence and insight, as well as building relationships, which allow us and our clients to realize the potential of emerging economies. If you would like to capitalize on our knowledge, insight and network, please contact us.

 

 

 

Mateusz Ciasnocha is constantly on a mission to “unleash dormant potential.” He specializes in agriculture, energy, and Africa, and is also passionate about innovation and entrepreneurship. Mateusz currently studies at ESCP Europe Business School and the University of Oxford, where he is receiving a Masters in Energy Management and Philosophy Certificate, respectively.

 

 

 

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