Emerging markets making investment grade

Serious Money: Emerging markets have come of age, most notably in Asia. Following a turbulent adolescence in the 1990s, they have grown up and are bigger and stronger than ever.

The market capitalisation of the MSCI Emerging Markets index exceeded $2,000 billion (€1,561 billion) earlier this year, up from just $500 billion four years ago, while today almost 40 per cent of emerging market debt is investment grade as against just 3 per cent a decade ago.

Not surprisingly, a handful of corporate giants has emerged, including the Russian gas firm Gazprom and several Chinese concerns, including Petrochina and China Mobile. Indeed, Gazprom's market capitalisation exceeded $300 billion earlier this year, making it the world's third-largest company, ahead of household names such as Microsoft and Wal-Mart. It would appear that emerging markets are simply too big to ignore.

Emerging markets have by and large put their economic houses in order and have consequently become attractive destinations for foreign direct investment. Several countries underwent severe financial crises in the 1990s and required substantial assistance from the International Monetary Fund (IMF). Large adjustment programmes were introduced, which included a reduction in foreign debt, the diminution of inflation and further integration into the world economy.

The results of these programmes speak for themselves. Public debt as a percentage of gross domestic product (GDP) has dropped eight percentage points since 2002 to below 60 per cent today. Inflation, which averaged more than 50 per cent in the mid-1990s, is now running in single-digits.

The transformation in Latin America has been particularly impressive. Public debt to GDP has declined by 13 percentage points on average to 52 per cent, while inflation, the region's perennial problem, has largely been defeated.

The dramatic improvement in economic fundamentals combined with increased integration into the world economy has enabled several countries to financially bulletproof their economies.

Unlike the 1990s, when emerging markets ran persistent and unsustainable current-account deficits, they are now running record surpluses. Additionally, they have become increasingly attractive destinations for foreign capital and, unlike a decade ago, the majority of capital inflows originate from overseas businesses and not portfolio inflows, which is notoriously fickle.

Including foreign direct investment, emerging markets ran record surpluses last year - even if China's $150 billion surplus is excluded.

Record surpluses place upward pressure on exchange rates and, to counter this effect, emerging markets have been accumulating foreign exchange reserves at a staggering pace. Reserves have been accumulating at an annual rate of $250 billion since 2000 - or roughly 3.5 per cent of annual GDP in aggregate. This is almost five times higher than the level experienced in the early-1990s. The absolute amount of foreign exchange reserves today exceeds short-term debt by a substantial margin, which means that many emerging markets are virtually immune to currency crises of the sort that haunted them in the 1990s.

The build-up of excessive foreign exchange reserves does not however, come without cost. Interest rates are kept artificially low, which has inflationary implications. Real interest rates in emerging Asia have declined from more than 9 per cent in the late-1990s to just 1 per cent today. Latin American rates have dropped from more than 15 per cent over the same period to just 3 per cent.

The inflationary implications have been minimal in most countries so far due to global excess capacity. Although excess capacity has dropped considerably in recent years, as reflected in the surge in commodity prices, a prolonged slowdown in the US economy should enable emerging markets to avoid an inflation problem.

The accumulation of reserves can also entail significant fiscal costs when domestic interest rates are higher than the rates available on foreign currency. For example, the annual cost in Latin American countries doubled in the early-1990s, which weakened their fiscal positions and undermined their inflation credibility.

The situation today couldn't be more different. Several countries, most notably China and Singapore, are earning a positive carry as short-term interest rates are well below comparable rates in developed markets. Additionally, the steady decline in bond yields in recent years has generated capital gains for countries with long-term foreign currency assets.

Although the underlying fundamentals in emerging markets are excellent, the military coup in Thailand and the murder of a prominent journalist in Russia have reminded investors that political risks have not vanished.

Furthermore, political developments in the US following the Democrats' success in the midterm elections may ease the threat of military confrontation with Iran and North Korea, but it almost certainly increases the threat of rising protectionism at some point.

The economies of Asia and Latin America have emerged from the crises of the 1990s in better shape than ever and are no longer as tied to the fortunes of the developed world as they once were.

Emerging market valuations are broadly attractive relative to the developed world, while relative earnings momentum is clearly in their favour. Investing in emerging markets is not so much an option as a necessity.

Charlie Fell is an independent consultant and lectures in finance and investment at UCD and the Institute of Bankers in Ireland