By Irina Miklavchich, CFA, Head of Emerging Market Equities, EMEA
Global emerging markets have faced significant headwinds over the last few years, primarily as a result of the slowdown in Chinese growth and significant declines in commodity prices. More recently, the expectation of U.S. rate hikes has also negatively affected sentiment. However, as global growth looks increasingly sluggish, monetary conditions in developed countries are likely to remain accommodative for a prolonged period of time.
The current tightening cycle in the U.S. is likely to be very shallow, alleviating pressure on emerging market countries as the cost of attracting foreign capital remains low. Countries that are not dependent on commodity exports are well-positioned to benefit from domestic-led growth. We are finding opportunities in places like Eastern Europe, India and Mexico. We believe for this group that macro imbalances have largely dissipated, so growth can move forward on a sustainable path.
Exhibit 1: Current accounts as a % of GDP
Sources: Columbia Management Investment Advisers, LLC, Bloomberg, IMF, March 2016
Reform in Latin America
Latin America has been particularly hard hit given its heavy dependence on commodity exports, so we are encouraged that Argentina has begun implementing an ambitious reform agenda following the election of a new government last fall. Initiatives enacted include the removal of capital controls, allowing the currency to float more freely and the ending of agricultural export taxes. Argentina has also reached a provisional agreement over the long-running dispute with some of its creditors, which should pave the way for it to access international bond markets. The reforms have been well-received by investors, with the Argentinian equity market performing strongly year to date. However, the road to reform in Brazil is likely to be much longer, requiring the political will to embark on the difficult and painful process of structural economic reform.
Chinese GDP is at risk
But emerging markets investors are, of course, still looking to China, which faces two key problems. First, the pace of fixed asset investment (FAI), which accounts for half of Chinese GDP, is decelerating. The main components of FAI are real estate investment, infrastructure and corporate capital expenditure, and it's the first of these that we consider the most problematic. We do not believe there will be enough demand over the long term to sustain China's current rate of property build, and any slowdown will also hit infrastructure investment. If we combine investment in real estate, related infrastructure and auxiliary industries (e.g., steel or cement manufacturing), something close to a quarter of China's GDP is at risk of a slowdown and possibly negative growth.
How will China tackle its debt problem?
The second problem China faces is a rapid build-up of debt in its economy. FAI-led growth resulted in debt accumulation both by the corporate sector, as well as by provincial governments, which were at the forefront of infrastructure investment. Now, as the investment cycle is decelerating, heavily indebted companies find that their cash flow is not sufficient to repay debt, and in some cases doesn't even cover interest payments. Whether China has the resolve to go through a painful process of shutting down idle capacity remains a key question. However, first steps toward addressing overcapacity in the steel and coal mining industries have been made with the government creating a 100 billion yuan ($15.27 million) fund to cover layoffs in those sectors.
Exhibit 2: China's leverage is rising quicker than its GDP
Sources: Lombard Research, BIS, Bloomberg, June 2015
Impact of a weaker yuan
China's long-term goal is to increase consumption as a share of GDP, but we have doubts whether consumption can grow at the double-digit rate of the past when construction and associated industries are under pressure and may start shedding jobs. Therefore, we believe that China will have to rely more heavily on export-oriented industries for job creation. To that end, following years of rapidly rising wages in China and an appreciating currency, the competitiveness of Chinese exporters has been somewhat eroded. A weaker yuan could help restore the position of Chinese exporters, though sluggish global demand will pose a constraint. Unfortunately, competitive currency devaluation globally looks increasingly likely with China joining the game.
In this context, both the commodity exporters to China and the economies that compete with China in export markets (e.g., Korea and Taiwan) will be affected negatively from the weaker yuan. While there is still a significant amount of capital that would like to exit China, and Chinese corporates still have outstanding debt in FX, ultimately the weakness of the currency is not a problem in itself. Once the currency adjusts to a more competitive level, the country's significant trade surplus will help stabilize capital outflows. The question in my mind is whether, in the shorter term, capital flight could prick the debt bubble, leading to a disorderly credit unwind.
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