While the European and US markets are suffering, emerging markets continue on their upward trajectories, indicating that the drivers of world growth have changed. Edward Russell-Walling reports.
Something is different this time around. Or is it? When European and US investors take fright, emerging markets usually suffer first and worst. But this time, as developed markets become more volatile and introspective, their emerging cousins sail serenely on. Some say a secular change has taken place.
Not everyone is convinced that a new page has been turned, but the facts of the moment are undeniable. While London and New York agonise over credit crunch fallout, resurgent inflation and the threat of recession, São Paolo and Moscow, Bombay and Shanghai are busy setting new records.
The difference has been starkly visible in share prices. “The proportion of total equity investible capital in emerging markets is a significant multiple of what it used to be,” says Citigroup ECM managing director Crispin Osborne. “That makes knee-jerk reactions – of the kind you tended to see in emerging markets in the past – less likely. But we didn’t anticipate that they would outperform as strongly as they have done since August.”
Gap opens up
A gap is also increasingly apparent in primary market activity. Developed markets had an energetic first half and 2007 looked as if it would be a fabulous year all round. But, as the credit crisis damaged confidence and took private equity out of the game, the second half was much more muted, in initial public offerings (IPOs) and mergers and acquisitions (M&A) activity as well as in the more obvious casualty zone of debt issuance.
By the time 2007 ended, equity capital raising on stock exchanges in developed markets was a mere 6% ahead of 2006, at $640bn ($605bn), according to Thomson Financial. But emerging market corporates had not paused for breath: over the same period, total equity issuance in their own markets leapt by 75%, from $198bn to $348bn. Two-thirds of that came from the four BRIC countries: Brazil, up 195% to $39bn; Russia, up 61% to $32bn; India, up 112% to $35bn; and China, up 74% to $121bn.
Among the most eye-catching flotations of the year were PetroChina (which raised $8.9bn), Russia’s Vneshtorgbank ($8bn), Brazilian stock exchange Bovespa ($3.8bn) and DP World (nearly $5bn), which chose to list only in Dubai (see Team of the Month, page 42). All were hugely oversubscribed.
In 2007, emerging market corporates and sovereign wealth funds (SWFs) also spent more money than ever before on acquisitions. They announced M&A deals worth $620bn, 39% more than in 2006, according to Thomson Financial, and five times the value of transactions in 2004. Although merger values out of Brazil and India decreased against a busy 2006, Russia and China were the stars. The value of Russian acquisitions rose by 124% to $100bn, while China’s were up 109%, at $84bn. Tellingly, the value of deals in which an emerging market corporate acquired a developed country target grew by 63% to $232bn.
This is a trend, not an overnight sensation. Although emerging market corporates are now forcing the pace, the phenomenon dates back to about 2003, when international investors last recovered their nerve. In the past five years, the Morgan Stanley Capital International emerging market index has more than quadrupled in dollar terms. The Brazilian market has risen an extraordinary 900% over the same period, the Czech Republic’s by more than 600%, and Turkey’s, Argentina’s and China’s by more than 500%.
Search for yield
Part of the explanation is investors’ search for yield and a spreading taste for alternative assets. But it reflects, above all, a growing faith in emerging market corporates and the economies in which they operate. A prevailing theory is that many of them are decoupling, once and for all, from the economy of the developed world. Its proponents argue that a revolution has been taking place and that certain long-term trends have been supplanting short-term cyclical influences.
Historically, emerging markets have been “growth-rich but capital-poor”, as Kerim Derhalli, Deutsche Bank global head of emerging markets equity, puts it. To attract imports of capital, they needed undervalued currencies and higher real rates and spreads.
“So they were linked to the economic cycle in the West, mainly via the US, and there was a high correlation between that cycle and short-term US interest rates,” says Mr Derhalli. “The way to be in emerging markets was to sit in London and New York and intermediate those capital flows. But the world has changed absolutely fundamentally.”
Change of drivers
The US, Europe and Japan are no longer the drivers of world growth. According to the IMF, emerging markets now account for 73% (adjusted for purchasing power) of global growth, and some say this is merely a return to the pre-existing balance before the industrial revolution tipped the scales in favour of the West.
“It’s not an aberration, but a return to the natural order,” Mr Derhalli argues. “So the correlation has to change or the tail is wagging the dog.”
One of the triggers of change was 9/11, or rather the defensive and protectionist US response to it: freezing assets and preventing foreign takeovers of certain US interests. That introduced the concept of US political risk and made people ask themselves where else they could invest. One answer was to invest in their own, or each other’s, infrastructure and economies.
The opening of markets – China’s not least – under the auspices of the World Trade Organization, has been key to the evolution of emerging economies, alongside the spread of better economic and corporate governance. Growth happened to kick in at the bottom of the commodity cycle, after a long period of underinvestment in capacity, and the resulting boom has resulted in a mammoth transfer of wealth from commodity consumers to producers (invariably emerging economies). The results have included positive trade balances, falls in external debt, rises in gross domestic product and the general spread of wealth. Most agree that this phase of the commodity cycle will run for some time.
Another long-term influence, demographics, suggests there will be booming, young populations in most emerging markets. This reinforces a need for more social infrastructure – schools, universities, hospitals and roads – and a rise in spending on major projects. As income is redistributed, a rising middle class in countries such as South Africa, Brazil and Russia is spending more on cars, fridges and TV sets. And consumption means growth. “Emerging markets are now growth rich and capital rich, and that’s a very different paradigm,” Mr Derhalli insists. “We’re living in a post-global world.”
Corporates benefit
Emerging market corporates are front-line participants and direct beneficiaries in all of this. As they prosper, so we see the emergence of strengthening regional – as opposed to global – economies in central Europe, north and south Asia, Latin America and even, one day soon, in Africa. Capital flows no longer pass inevitably through London and New York.
“Intra-regional flows have become more important,” says Matthew Koder, Hong Kong-based global co-head of ECM at UBS. “Cross-border integration in Asia, for example, means more capital flows between Asian countries.”
Earnings growth, high return on equity, low leverage and political stability combine to make many emerging markets corporates attractive to investors. “Asian corporates are less affected by credit issues than those in the US or Europe, and their current valuations – adjusted for expected earnings – look very appealing by historic or absolute metrics,” says Mr Koder.
Debt capital markets (DCM) have been more sensitive to the credit crunch, though they held up well to begin with. Indeed, it was mostly a lively year for emerging markets DCM. There was plenty of activity out of Russia (including wider currency diversification), a step-up in Latin American issuance in currencies such as the Mexican peso and Brazilian real, and new life in Africa, where novelties included an issue in Nigerian naira, and Eurobonds from Ghana and Gabon.
Worldwide corporate bond issuance (including financials) eased to $3170bn in 2007 (compared with $3240bn for all of 2006). Within that, emerging markets issuance was somewhat ahead of 2006, at $348bn ($325bn).
“By November, emerging markets had caught up with the general malaise, with significant reductions in primary market deal flow and secondary liquidity,” says Richard Luddington, UBS head of CEMEA DCM. “Most issuers decided to wait until 2008.”
Some corporates still needed to borrow, not least to finance their newly acquisitive tastes, but as the year’s end drew closer, they were turning to the domestic market or drawing down bank lines of credit.
Emerging economies have been flush with cash before, of course, most famously after the oil price hikes of 1973 and 1979. They have then blown the money on what turned out to be the wrong choices, such as ploughing it into Latin America.
Fawzi Kyriakos-Saad, head of emerging markets EMEA at Credit Suisse, is not yet convinced that the same will not happen again. “Their access to reserves allows them to invest in assets available at a discount in other countries,” he observes. “But they should also focus on developing their own economies and infrastructure. There are still gaps. So now is the test.”
That will turn on whether their investments are used simply to generate returns or to foster development in their own and other developing economies – as China is doing in Africa. The biggest opportunity, Mr Kyriakos-Saad believes, is in the financial sector, where stocks are depressed and expertise can be quickly bought. The Abu Dhabi Investment Authority recently acquired a stake in Citigroup, for example, Singapore has invested in UBS and China in Morgan Stanley.
“The real test is whether these SWF investments will also be leveraged for their own financial institutions, which could benefit enormously from the expertise of international banks,” he says. If developing countries fail these tests, he maintains, the much-trumpeted ‘decoupling’ will not last.
