Emerging markets are hot. The four BRIC countries have dramatically outperformed all of the old, tired developed markets. Russia’s Micex index is up 48 percent (RSX). China’s Shanghai Composite index is up 39 percent (PGJ, FXI, GXC). Brazil’s Bovespa index is up 21 percent (EWZ) and India’s BSE Sensex 30 index is up 14 percent (PIN). The obvious conclusion is that it is time to jump in with both feet because these markets are going to go through the roof. I would suggest some caution.
The first reason is information. Emerging markets are far more volatile than markets in developing countries. I believe that the reason is information. Emerging markets are dominated by family owned and state owned companies. This combined with weak legal infrastructures and conflicts of interests suggests that the legal disincentives for revealing accurate, timely and complete information are not there. So these markets often trade on what Robert Shiller refers to as “stories” that is plausible tales and forecasts—for example, that house prices will never go down. In addition, Shiller points out another aspect of irrational behavior that is particularly prevalent in these markets, corruption. It is not that people in emerging markets are more or less corrupt than people in developing markets. Certainly the US market has had its share of villains. It is just that the weak legal infrastructures and relationship based systems makes it easier for them to be corrupt. So booms and busts in emerging markets tend to follow each other in rapid succession and may or may not reflect economic reality which may or may not be possible to forecast based on the accuracy of the information available.
The second reason is real estate. Many governments and commentators have recently become fond of blaming the United States. It makes good copy to accuse Wall Street’s financial excesses around the housing market for forcing the world into recession. There is no question that the US financial meltdown did trigger the problems. However, real estate booms were a feature of many economies all over the world. Some commentators have suggested that China’s recent problems were not so much the collapse of the export market, but the slowing of the real estate bubble that started to collapse as far back as 2007, when the government introduced various measures to keep it in check. Although there are signs that the real estate market is bottoming, others disagree. In a recent article, the Financial Times quoted Cao Jianhai, a senior government analyst who “expects urban property prices to fall as much as 40 to 50 per cent across the country in the next two years as a result of huge oversupply and a serious disconnection between prices and income levels.” The same article quoted Fan Gang, a prominent economist and member of the Chinese central bank’s monetary policy committee that the Chinese economy will only be able to “step out of the valley in one or two years’ time.”
In Russia the construction industry grew at a rate of more than 16 percent in 2007, accounting for over 5 percent of gross domestic product. Last year Russian banks doubled their exposure to real estate loans mostly to developers. In the last four months market rents have fallen by about 50 percent in the office and retail sector, with the Moscow market being the worst hit. The collapse of commercial rents has dropped asset prices down 50 percent to 75 percent from their former peak levels. India is no different. Last fall the chairman of State Bank of India, India’s largest bank, said that he expected a 50% correction in the housing prices. As we have seen in the US the housing issues are at the heart of the recession.
The third is, of course, the banks. As the world economy collapses so do bank balance sheets. Non-performing loans are multiplying throughout emerging markets. The Chinese government is only funding a portion of its stimulus package. The rest is being financed by the banks, who, when ‘asked’, complied with a vengeance. The state owned banks spewed out almost three quarters of a trillion dollars in new loans in the first quarter alone, 90% of what the government expected to loan in the entire year. It is estimated by the World Bank that this government-influenced spending will account for three-quarters of China’s GDP growth this year. With so much lending going on in such a short period of time, the risk is that politically directed lending creates more overcapacity, poor rates of return and future bad loans for banks.
Some economists insist that much of this spending will be on infrastructure which will yield a handsome return on investment. Certainly building roads, bridges, schools and hospitals does bring the economy a good return, but only if these infrastructure projects provide cash flow to service the loan. Most don’t.
In Russia the corporate debt market is a total of $780 billion but of that $220 is short term that will come due by the end of 2009. It is estimated that the levels of bad loans for the banking system could rise as high at 20%.
In India the country’s central bank, the Reserve Bank of India (RBI) has been congratulating itself on what a wonderful job it has done in avoiding a financial collapse that has been plaguing most economies. In theory the 70% of the banking systems that is in government hands is sound. Even private banks are required to keep a large part of their deposits with the central bank or other state institutions resulting in capital adequacy of above 12 per cent. Often it is much higher because the state owned banks practice ‘lazy banking’. They help fund India’s provinces with the enormous amount of debt that they require, while restricting loans to the private sector. Still according to a survey last November all banks including the state owned banks reported a 24% rise in non-performing loans.
After the last recession at the start of this decade, both Indian and Chinese banks were swimming in non-performing loans. They were as high at 12% in India and the four state owned banks in China had dud loans over 30%. The bad loans were bad enough, clearing them off the books of the banks was worse. China did not really have a functioning bankruptcy law until 2007, and even now it is untested in courts. Most of the recent loans went to state owned industries, which really cannot go bankrupt. In India the court system is famous its backlog and cases lasting over ten years. What is considered a non-performing loan can vary widely between systems and regulators all over the world can be ‘flexible’ especially in a crisis when governments do not want to panic depositors.
In the US there is a well grounded debate as to what exactly is the level of bad debts on the books of our largest banks. Even with when the results of the famous stress tests are revealed there is a great deal of doubt as to whether the numbers actually reflect reality. In truth they probably will not. The issue of the exact number of the bad loans in emerging markets is worse.
So despite some of the good news about the global economy, investors should be cautious not to expect a repeat of the exuberance that was part of the emerging market story of the past few years. The combination of poor information, collapsed asset prices and an undeveloped financial and legal system will prevent the rapid growth from returning to these markets for some time to come. This does not mean that a trader cannot profit from dramatic fluctuations. It does mean that the time frame for trading strategies should be kept to a minimum and when in doubt, panic.
Disclosure: No Positions
