By Jonathan Anderson, Chief, Asia-Pacific Economist for UBS
From Caijing Magazine

To see where emerging markets are going in 2009, we need to review where they’ve been and why they’ve so far stood up to the world’s dramatic financial slump.

During the 1980s and 1990s, the emerging market world careened from one crisis to next. Aggregate real growth never exceeded 5 percent year-on-year during the 20-year period, and often fell to 2 percent or below, for a paltry average of only 3 percent year-on-year over the cycle.

Why such poor performance? The short answer lies in their weak balance sheets. After the boom years of 1955-’75, emerging countries built up a dangerous mix of debt, deficits, overextended banking systems and other economic distortions. In this environment, when developed countries entered recessions and financial markets fell, the emerging world was threatened with exchange rate crises and sovereign debt defaults.

Since 2000, however, the situation has changed radically. Aggregate emerging growth accelerated to 7 percent year-on-year and higher. This was not only due to rising China and India; most smaller economies shared in the growth boom as well. Looking at underlying economic data, the best explanation for the return to record-high growth lately was a post-crisis recovery across most regions, supported by favorable external positions and cleaner national balance sheets.

On the whole, emerging countries had historically low external debt, an unprecedented net creditor position against the developed world, balanced trade positions, small budget deficits and, most importantly, surprisingly low gearing, with only moderate expansion in credit as a share of GDP.
 

The main exception has been Eastern Europe, where the underlying macro position was much weaker. Rapid domestic leverage growth, large current account deficits and high dependence on external financing confronted many economies in the region, particularly among the Baltic and Balkan states, Ukraine and Hungary. Needless to say, this is where we saw the highest underlying risks as the 2008 global crisis unfolded.

These are economic fundamentals. However, there is another dimension: the behavior of asset markets and global investors. When we look at financial markets, the situation is very different, with one-directional and excessive gains in nearly every asset class.

In equities, for example, the 2003-’07 period was the strongest and most protracted episode of high global equity risk appetite seen in the post-war era, with historic low volatility levels, strong positioning in riskier portfolio categories, and virtually monotonic returns. Against this backdrop, and taking into account the return to strong real growth in the emerging world since 2001 as well, it should come as no surprise that this period also saw the biggest net equity inflows into emerging markets.

In turn, this led to a dramatic stock market boom. If we use January 2000 as a benchmark of 100, then both the MSCI World (which covers developed markets) and the MSCI Emerging Markets indexes began in 2003 at an index level of just over 50 in U.S. dollar terms. By late 2007, the MSCI World peaked at around 125 — a respectable doubling for a four-year period while the Emerging Markets index had risen to a dizzying 275, a five-fold increase over the same length of time.

Of course, some of this over-performance was due to underlying differentials in earnings growth, but much more was involved. For much of the past two decades, emerging equities traded at a sizeable valuation discount to developed markets on indicators such as price earnings ratios. But over the past five years, these metrics rose to a significant outright premium.

On the currency and debt front, perhaps the best measure of risk appetite is implied currency volatility in the options markets. The past half-decade saw an unprecedented, sustained decline in volatility — which generally corresponds to a rise in risk appetite in “tradable” emerging currency markets. As with equities, emerging bond prices kept rising. This was seen by the spread on emerging foreign-currency sovereign and high-grade corporate yields versus U.S. and European treasuries. From late 2002 through mid-’07, the spreads on emerging debt declined steadily and sharply.

Emerging currencies alone did not appreciate wildly. But a strong global risk appetite led to a rare period of almost absolute stability against the developed countries, as central banks accumulated foreign reserves at a record pace. Equally important, given a weakening U.S. dollar against the euro from 2003 to ’07, emerging currencies steadily strengthened against the dollar. With appreciation and interest rates almost uniformly above U.S. levels, a continuous and sizeable build-up of long positions in a number of emerging nations currencies occurred.

The process was aided by what can be described as a “great commodity bubble” on its last legs from mid-2007 through summer ’08. Overall commodity prices had been rising since the turn of the century, doubling between 2001 and mid-’06, then increasing 60 percent in the latest rally from 2007 through mid-’08. This increase was fueled in part by global liquidity and speculative conditions, but also to a very large degree due to an uninterrupted rise in Chinese demand, as the mainland economy grew by more than 10 percent year-on-year from 2003-’07 as net imports of crude oil and other resources hastened.

Since mid-2008, the emerging world has been hit by three shocks. First was the initial pullout from risky asset classes, which in the case of emerging markets meant equities; most local stock markets peaked in October 2007 and fell 30 to 40 percent through the middle of 2008. Then came the capitulation of commodities, as the Chinese property and construction downturn pulled the last supports from inflated and overleveraged markets. As 2008 drew to a close, the broad commodity index had already fallen more then 50 percent from the peak, pressuring raw materials producers.

Finally, and most importantly, in the immediate aftermath of the Lehman Brothers debacle, global financial markets simply melted down with “manic deleveraging” across all asset classes. For the first time, emerging exchange rates came under intense, widespread attack. International debt markets exploded, and both government and corporate paper sold off sharply. Equity and commodity prices saw sharp sell-offs. And even global trade finance, long considered the safest credit category, began drying up.

By contrast, the fourth shock against emerging markets — the developed countries slowdown — didn’t appear in full force in emerging export data until lately. Exports in U.S. dollar terms were still rising as of October 2008 but will slow considerably in 2009.

What next? Emerging markets have reached a Great Divergence. After the sudden onset of global panic and deleveraging, there was still a gaping difference between what’s priced into international equity and bond markets and what was happening in domestic financial markets. As far as we can measure, the actual damage to growth and credit availability in the emerging world was relatively moderate, and concentrated in higher risk cases in Eastern Europe and elsewhere: Hungary, the Ukraine, Pakistan and Serbia went to the International Monetary Fund for help. Other Eastern European countries slipped toward recession, and Russia experienced a serious banking crisis. In Latin America and Asia, regional balance sheets were in much better shape coming into the crisis.

On the other hand, the longer the current environment of absolute illiquidity persists, the worse it will get. Our main concern for the rest of the emerging world is the risk of continued global panic, deleveraging and liquidity shortages.

Brazil, India and China may have more insulation from the outside world and better relative conditions at home. But there is a large “middle group” of countries including Turkey, Indonesia, South Africa and others  not facing immediate risk today, and indeed should do well if investment risk appetite and access to global finance returns. Yet they will face increasing pressure if markets continue to falter.

Meanwhile, watch China and Russia. With Chinese authorities in full stimulus mode through spending, monetary easing and other measures to boost confidence, we see a good chance that construction and commodity demand will begin to recover by the middle of 2009. This could have significant, positive implications for market sentiment. On the other hand, Russia’s severe domestic banking system weakness has been surprising, making this economy a potential downside factor.