Professor Finds Many Fault Lines in Crisis

The term emerging markets is obsolete. They represent half of the world’s economy; their financial markets are large and liquid, with volatility, corporate governance and government policies very similar to those of developed markets. The traditional distinctions between emerging and developed markets, once pronounced, have disappeared.

Because of their high growth rates, emerging markets are now too large to be ignored. On a purchasing power parity basis, China’s gross domestic product is larger than Japan’s, India’s is larger than Germany’s and Russia’s is larger than the UK’s. The BRICs (Brazil, Russia, India and China) are as large as developed Europe. Surprisingly, the rest of the emerging markets (ex-BRICs) collectively command a greater share of the global economy than the US.

Even though emerging markets have very large economies, the common misconception is that they have fairly small, illiquid and volatile financial markets. This is definitely not the case. Because of faster economic growth, the out- performance of their financial markets in the past decade and the fact that many private and government-owned companies have recently been publicly listed, the market capitalisation of emerging markets has grown considerably and in total now represents 30 per cent of world market capitalisation, as much as the US. China now has a larger market cap than Japan. South Korea and Taiwan, two emerging industrial powerhouses, together have a larger market cap than Germany, and Brazil has a larger market than Australia.

Liquidity in these markets has also increased dramatically in recent years. So far in 2009, Chinese exchanges have traded more than the NYSE, South Korea more than France and India more than Canada.

Another argument against emerging markets is that they are too volatile and have unstable, unpredictable governments that leave them susceptible to coups or revolutions. In reality, however, volatility levels in emerging markets now nearly match those in developed markets. Even in the extreme market environment of 2008, emerging markets and developed market volatilities were very similar. So in terms of size, liquidity and volatility, emerging markets are on a par with developed markets and should not be discriminated against because of antiquated notions around these criteria.

Another popular knock against emerging markets is their reputation for poor corporate governance and less market-friendly government policies.

These criticisms are no longer warranted. Not only have emerging markets risen to higher corporate governance standards, but developed markets’ aura of quality in this area has also diminished considerably. Enron, Parmalat, WorldCom and Countrywide represent only a handful of examples in this regard.

Further, while the west lectured Asia and Latin America in the 1990s on government policy best practices, the reverse is occurring now as the US and Europe create a striking display of inconsistent and erratic policies often favouring special interests. The handling of, and policies surrounding, Lehman Brothers, Railtrack, GM, Fannie Mae, Northern Rock and Opel are just some recent case studies to ponder.

There is, however, one measure that highlights a clear and continuing distinction between emerging and developed markets: growth.

In the period 2003-2009, sales for “Emerging Markets, Inc” (an aggregation of publicly traded companies in emerging markets) grew 11 per cent annually versus 5 per cent for “World, Inc”.

We believe that this differential in growth will continue for three main reasons: the differentials in GDP and population growth will be maintained for the foreseeable future; many emerging markets’ basic needs have not yet been met, so starting from a lower base, consumption and investments will continue to grow faster; and from a risk standpoint their companies were and continue to be less leveraged, with higher interest coverage ratios than those in developed markets.

In fact their coverage ratios have improved significantly as interest rates in emerging markets have come down dramatically.

Emerging markets should matter a great deal for all investors, now and for the rest of our investing lives. Yet today they still represent only 12 per cent of the MSCI All Country World Index, while representing 30 per cent of the world’s market capitalisation, 50 per cent of the world’s economy and the world’s best growth prospects. Investors focusing on benchmarks will miss this opportunity.

The end of emerging markets is here. Investors who don’t catch on to this reality risk being left behind.

The writer is founder and chief investment officer of Everest Capital

China has had a good crisis. That became obvious at the “summer Davos” of the World Economic Forum, in Dalian, less than two weeks ago. Chinese confidence was palpable. But so was anxiety. The giant has survived the shock. But its recovery is driven by a surge in credit and fixed investment. In the longer term, China needs to rebalance its economy, by increasing consumption. It is time for the Chinese to enjoy themselves more. How unpleasant can that be?

The man who best captured both the confidence and the uncertainty was premier Wen Jiabao. He told the meeting that “the unprecedented global financial crisis has taken a heavy toll on the Chinese economy. Yet we have risen up to challenges and dealt with the difficulties with full confidence “. But he also admitted that the “stabilisation and recovery of the Chinese economy are not yet steady, solid and balanced”.

The data coming out of China suggest a powerful recovery is indeed under way. In the first half of the year, noted the premier, gross domestic product expanded 7.1 per cent. The September consensus forecasts suggest that the Chinese economy will expand 8.3 per cent in 2009 and 9.4 per cent in 2010. The Asian giant is expected to become the world’s second largest economy in 2010, even at market prices.

According to the Economist Intelligence Unit, domestic demand may expand by as much as 11.5 per cent in real terms this year. Such a surge in Chinese internal demand is exactly what was needed. Chinese household consumption is also forecast to grow 9.3 per cent (see chart). Yet, as usual, real fixed investment is the locomotive. It is forecast to grow 14.8 per cent this year. If so, it would have grown faster than GDP in all but one of the past 10 years. This rising ratio of investment to GDP, from an already high level, is not a strength but a weakness. It suggests declining returns on capital. It risks creating ever-rising excess capacity. Moreover, when growth rates finally fall, the collapse in investment is going to knock a huge hole in demand.

The heavy reliance on investment is not the only risk ahead. So, too, is the surge in credit and money (see chart). Many believe this is bound to lead to another upswing in bad debt and destabilising asset bubbles. The jump in the ratio of broad money to GDP is also worrying, coming after a long period of stability.

China, it appears, has saved itself. Has it also been saving the world?

The most encouraging development is the shrinkage of China’s current account and trade surpluses (see chart). Both exports and imports have fallen sharply, but exports have fallen further. Yet China’s trade has been so volatile (along with everybody else’s) that it is hard to be sure this will prove a turning point. Much will depend on the nature and pace of the global recovery. Moreover, the country will continue to run a substantial current account surplus and accumulate still more foreign currency reserves, even though they are already far larger than China needs for insurance purposes. After all, they reached $2,132bn (over 40 per cent of GDP) in June of this year.

That would be equivalent to official holdings by the US government of $6,000bn (€4,000bn, £3,670bn) all denominated in the currencies of other countries. It is little wonder such a huge exposure makes the Chinese government nervous. But nobody asked the Chinese to do this. On the contrary, US policymakers have consistently (and wisely) advised them to do the opposite. Having made what I believe was a huge mistake, the Chinese government cannot expect anybody to save them from its consequences.

A substantial appreciation of the Chinese currency is inevitable and desirable in the years ahead. The longer the Chinese authorities fight it, the bigger their losses (and the pain of adjustment) are going to be. What they have to do is cut those losses, by ceasing to accumulate yet more reserves. As Morris Goldstein and Nicholas Lardy of the Peterson Institute for International Economics argue, in an excellent recent study, the policies required to do this are also needed to help rebalance the economy in the long term.*

It is important to understand how distorted China’s economy now is: in 2007, personal consumption was just 35 per cent of GDP. Meanwhile, China was investing 11 per cent of GDP in low-yielding foreign assets, via its current account surplus. Remember how poor hundreds of millions of Chinese still are. Then consider that the net transfer of resources abroad was equal to a third of personal consumption.

This is surely indefensible. The premier may even agree. In Dalian, Mr Wen remarked that “we should focus on restructuring the economy, and make greater effort to enhance the role of domestic demand, especially final consumption, in spurring growth”. An appreciation of the real exchange rate, ideally via a rise in the nominal exchange rate, would help. Not the least of the distortions of the current regime is the need to keep interest rates low, to curb capital inflows. This shifts massive amounts of income from households into corporate profits.

Whether China’s partners will raise the issue of exchange rate policy in Pittsburgh, at the summit of the G20, is, alas, unclear. The Chinese are probably powerful enough to prevent it. But President Hu Jintao will surely complain about US protectionism. I sympathise with him. I would sympathise far more, however, if China’s foreign currency interventions, combined with the sterilisation of their natural monetary effects, was not such a massive subsidy to its exports.

The big point for China is that, like it or not - and it is perfectly clear to even the casual visitor that many Chinese dislike it intensely - the explosive rise in trade and current account surpluses of the mid-2000s is an unrepeatable event.

The short-term rebalancing of this year, via a huge credit expansion and surge in fixed investment, is a temporary expedient. It must lead to a rebalancing of the Chinese economy towards consumption. This is in China’s interests. It is also in the interests of a better balanced world economy. If the successful response of this year leads in this direction, the crisis will have brought great long-term benefit.

“A crisis,” as they like to say in Washington these days, “is a terrible thing to waste.” They may be ungrammatical. But they are right - and not only for the US.

* The Future of China’s Exchange Rate Policy

martin.wolf@ft.com

Hu Xiaolian has been the director and Communist party secretary of China’s State Administration of Foreign Exchange since March 2005 and a deputy governor of the People’s Bank of China, the central bank, since August 2005.

Ms Hu was born in 1958 and joined Safe in 1984 after obtaining an MA from the graduate school of the Institute of Finance Research under the central bank. She was among the first batch of graduates.

She served successively as deputy administrator of Safe and assistant governor of the People’s Bank of China and was named the first general manager of Central Huijin, the government holding company that manages the state’s stakes in the largest banks.

She was elected an alternate member of the ruling Communist party’s central committee at its national congress last October, illustrating the emphasis the central government places on managing the country’s ballooning foreign exchange reserves.

According to some reports, Ms Hu spent four months as a visiting scholar at Harvard university in 2002.

China’s economy is on track to hit the government’s growth target of 8 per cent this year following increased government spending and a surge in bank lending in the second quarter.

The economy expanded at an annual rate of 7.9 per cent in the three months to the end of June, the National Bureau of Statistics announced yesterday, with investment, industrial production and retail sales all contributing to higher output.

China’s accelerating growth has already lifted prices of commodities such as iron ore and copper and boosted economic output of raw materials exporters such as Australia and Brazil.

The speed of the Chinese recovery, without an accompanying boost in demand from advanced economies in North America and Europe, has surprised economists and led the International Monetary Fund to revise higher its outlook for the world economy earlier this month. The Chinese government’s mass injection of money into the economy has also pumped air back into the asset price bubbles in the domestic property and stock markets.

Li Xiaochao, a spokesman for the NBS, said the economy “had stabilised with increasing positive changes” after dipping sharply at the end of last year and expanding at an annual rate of only 6.1 per cent in the first quarter, leading many economists to believe that the government would not be able to meet its year-long growth target of 8 per cent. But the government’s pump-priming has turned the economy round, prompting rapid revisions by many economists, and the World Bank , to upgrade China’s outlook.

“The Rmb1,530bn [$224bn] in new loans in June brought total new lending in the first half of the year to Rmb7,400bn, or almost one quarter of our estimated 2009 GDP,” said Wang Tao, of UBS, in Beijing. “We now expect total new lending in 2009 to reach Rmb9,000bn, a speed of re-leveraging unprecedented in China’s history.”

The bank lending and fiscal spending has driven fixed-asset investment, the prime engine of growth, up 33.5 per cent in the first half of the year compared with the same period in 2008.

Government incentives for consumption, such as rebates on buying cars and white goods, helped support retail spending, which expanded 15 per cent in the first six months of the year. At his press conference, Mr Li appeared to suggest that the government was not yet ready to apply the brakes to the economy. Although momentum was clearly picking up, he said the recovery was “unbalanced”.

However, the faster-than-expected quarterly data may strengthen the case already argued internally by the central bank and the bank regulator for the stimulus to be reined in.