Over the last 10 years, emerging markets moved from an esoteric asset class, to mainstream investment, to a significant destination for global portfolios now that several moribund western economies have low single digit growth. Consider Turkey, once dubbed the ‘sick man’ of Europe – now showing solid growth, healthy demographics and emerging from the global financial crisis (certainly in its financial sector) in better shape than many of its Eurozone neighbours. There are varying estimates of growth in the wider emerging markets basket – we could take an estimated figure of 6% growth in global emerging markets in 2011 compared with 2% in developed markets. These new markets have also become in themselves significant drivers of the growth in developed markets and exert significant political and commercial influence beyond their own borders. China’s decisions on currency revaluation, controls over its booming real estate sector, energy investment and infrastructure spending, or the international ramifications of its export restrictions on rare earth metals affect developed markets to a far greater degree than in previous decades (and drive global commodity demand). With $2.85 trillion in foreign reserves, China has the capacity to be a significant inward investor in developed and other emerging markets – signing loans of at least £70 billion to developing governments and companies in 2009 and 2010, according to Financial Times research.
Jim O’Neill, the Chairman of Goldman Sachs Asset Management, declared that emerging markets, which drove GS’s Emerging Market Debt Fund to quadruple its value, would be rebranded as ‘growth markets’, but added that “stuff doesn’t grow at that rate forever without it possibly being a mistake.” In many cases, emerging markets are not structurally geared to sustain massive growth levels without regular recalibrations – such as those which occurred in 1998, 2001 and 2008. Some might argue that the downswings are shorter and less pronounced than the emerging markets bull years, so the corrections are worth taking. And whatever the view on frequency of those crashes, global markets are now locked together far more tightly. Not only EM with EM but as well, EM with developed markets (See Fig.1). So the next correction in emerging markets could carry far more downside, with impacts on commodities, manufacturing, export markets and labour flows and inter-country remittances. What are the possible signals of an impending crash? Unparalleled hype and optimism, combined with fulsome predictions of growth and unlimited potential – exactly what we are seeing in some of the more frenzied commentary on emerging markets. It pays to understand some of the underlying weaknesses in these growth regions.
Emerging market political risk
Emerging market risk is driven by the interplay of politics and economics; in emerging markets political decisions (often taken behind closed doors and hugely subject to the influence of mercurial personalities) can play a disproportionate role in determining economic performance and stability. Not to overstate this – we have seen political deadlock in plenty of developed markets – the current state of the US Congress for example, or protectionist threats in Australia. But we are about to enter a year in which political responses to external and internal pressures (from elections to international currency manipulation) will affect the outcomes for many major emerging markets.
What are the key risks on the horizon for 2011 and beyond? There are short term risks (election violence, currency controls, government collapse), medium term stories (food price inflation, impact of oil discoveries, rising energy costs), and then a host of longer term EM risks (conflict for water resources, environmental concerns, demographic decline and political succession planning). We have laid out some key themes for 2011 that will affect the growth trajectory and stability of key countries.
Closed politics and succession
A number of emerging markets are facing uncertainty over the direction of stagnating or entrenched regimes. In some markets, a static political environment can be positive for investment – consider Kazakhstan, where succession is not an immediate problem and where the scope for political discontinuity is limited. By contrast, Egypt has experienced high levels of public unrest over the process of succession for Hosni Mubarak, prompted in large part by widespread dismay over the potential choice of his son Gamal as successor and by the lack of political openness. Thailand, although now much calmer than last year, faces a looming royal succession issue and persistent structural problems with its political system. We have seen an example this month of such volatility in Tunisia, a corrupt and ossified regime. Whether it will spread to other regional one-party regimes is open to debate (the MENA region is not homogenous) but it highlights the risk from a failure to reform and simmering social discontent. Clarity over succession will continue to be a major factor for EM stability in 2011.
Several key elections are scheduled to occur in emerging markets in 2011. Including Egypt, 26 countries will hold elections this year across the African region alone. Elections in emerging markets often serve simply as a channel for redistributing wealth and patronage – Africa illustrates this vividly. Though election violence in Guinea and Cote d’Ivoire was exceptional, elections in oil-rich Nigeria in 2011 will be vulnerable to tension over wealth redistribution and elite rebalancing. With a new oil belt in West Africa stretching from the Jubilee field in Ghana to Sierra Leone, political strains over new mineral wealth will be heightened. In Europe, Turkey’s summer elections promise an almost certain AKP win. But this will be accompanied with continued noise from the military, opposition and media, and a slowdown in the ability of parliament to enact legislation. Meanwhile, elections to Russia’s Duma in December may create a slew of new ‘micro-factions’ within the assembly (although the main event to watch is the Presidential election due in March 2012).
Inflation levels rising
Along with currency appreciation, commodity price rises and environmental factors, inflation – and most acutely food price inflation – could prove crucial to EM stability (See Fig.2). We are likely to see increased social unrest, particularly in countries where disposable income is low. Countries such as India – food price increases of 16.9% in December 2010 – Pakistan, Bangladesh, Morocco and Nigeria, among others, are vulnerable. Even relatively stable countries such as Russia (badly hit in 2010) enacted grain export bans to limit the risk to domestic food markets (as did Argentina, Cambodia, Kazakhstan, China, Ethiopia, Malaysia and Zambia). Political responses to inflation matter, particularly in countries such as India, where over 500 million people live in relative poverty and are highly dependent on basic foodstuffs. What’s more, rising dollar liquidity (See Fig.3) is likely to increase pressure on foodstuff price inflation.
Sustained growth and diversification
Investors are betting heavily on the larger growth markets – China and Brazil – lured by demographics, consumer demand or natural resources; but structural issues remain. The biggest challenges for the EM countries will be sustaining this growth through coherent policy decisions on fiscal policy, infrastructure development and diversification. Brazil faces multiple challenges to sustain the economic legacy of Lula, while keeping the investment climate open (watch mineral taxes and restrictive land ownership laws). China will need to maintain a careful balance between excessive growth rates, reining in bank loans, real estate investment and inflation – policy decisions will above all seek to preserve social stability, with economic policies that cement the authority of the centre. It has perhaps a flashier short term story to tell than India, but longer term the demographic picture is far more positive in India than China.
In short, investors should not ignore the underlying political risks in these economically attractive markets. Key to this is monitoring key ‘soft’ indicators such as policy responses to inflation, restrictions on foreign investment, election outcomes, and high level elite politics. These are all central to a coherent EM strategy. Finding a way of measuring these variables, of course, is what any risk analysis must help investors do.
Philip Worman is a partner in GPW’s Political Risk group. GPW is a consultancy which provides investors with insight into politics, regulation and people risk in emerging and frontier markets around the world.