By Henry Teitelbaum, Editor, P3Planet.com
Considering the growth and scale of emerging markets these days, it’s somewhat baffling that stocks, bonds and currencies in these markets still get hit hardest when global financial markets turn volatile.
GDP from emerging markets by some measures now tops 50% of global output. Yet, time and again, risk-off situations emanating from western markets, most notably the US quickly lead to huge flights of capital out of these markets. This often brings disproportionate value destruction for investors, lasting damage to economies, and extreme misery for the poor and vulnerable.
And it’s happening now. The trigger is collapsing global oil prices, but the selling is increasingly indiscriminate, with contagion spreading across regions and continents regardless of fundamentals.
So has anything really changed?
The answer is yes, but we may have to wait to see it. If this volatility event plays out anything like the bout that hit emerging markets in January, we will see differences emerge in the level of resiliency within individual country bond, equity and currency markets once the initial shock passes. What we will also see is that the more successful emerging economies will bounce back quickly and convincingly, while others continue to struggle.
Building Volatility-Resistant Economies
Macro-economists have long pointed to current account deficits, external debt and foreign currency reserve levels as factors that determine an individual country’s susceptibility to these events. They also look at the extent to which domestic capital markets have been able to deepen and diversify to resist liquidity shocks.
But investors also need to look more closely at issues of governance in the broad sense. I’m not just talking about clean government, but at the setting of long-term goals and the management of fiscal and social policies in ways that help to overcome market fragility.
One important, and under-utilized policy tool for fostering stability and resilience in emerging markets is in encouraging investments in critical economic and social infrastructure. Whether done directly through government investment or by enabling private sector delivery, a program of investment in roads, port, educational and healthcare infrastructure can channel domestic savings and attract foreign private capital towards productivity- and quality of life-enhancing improvements to these essential public assets.
The recent slowing of growth in major emerging markets such as China, India, Brazil and Indonesia makes it particularly important for political leaders to be considering programs like these now. One reason is that the large amount of readily accessible foreign investment capital that is available around the world is likely to decline sharply when interest rates start to rise. The other is that we appear to be at the end of an extended cycle of growth in many emerging markets. Being aware of this, foreign portfolio managers are becoming more selective in where they invest in emerging markets.
Two Sides to Foreign Investment
Foreign investments, particularly in fixed income securities, have long been a major force behind the growth, but also the volatility that emerging markets have displayed over the past 20 years.
According to the IMF, gross capital flows to emerging markets rose by a multiple of five since the early 2000s.
What is, or should be of greater concern to these countries is that the most volatile of these flows — bond investments from global portfolio managers — have grown the most, and now constitute the largest single source of foreign investment. (http://www.imf.org/External/Pubs/FT/GFSR/2014/01/pdf/c2.pdf)
Against this backdrop, some emerging markets have made enormous progress toward creating stronger domestic markets that are able to manage the ebb and flow of this investment. This has included policies that have encouraged the development of deeper banking systems with greater domestic participation, as well as more diversified markets and asset classes for investors to choose from. For those countries that have done the most to foster these institutions and support domestically originated investment, there’s less to be concerned about should there be a spike in volatility outside the country. For countries that haven’t, their exposure to volatility has never been greater.
Building A Virtuous Circle
Infrastructure investment can help to reduce this exposure while creating both short- and long-term value. The virtuous circle that is generated through this approach starts with job creation in the near-term, and continues through better services, a more productive economy, and a more attractive place to invest in the long-term. Depending on the amount of private investment that can be channeled towards these infrastructure, the benefits can even be achieved without creating unmanageable strains on government finances.
A recent IMF study (http://www.imf.org/external/pubs/ft/wp/2011/wp1152.pdf) found that the long-term fiscal multipliers for government investment in infrastructure in developing economies are around $1.6 for every $1 of investment. That’s higher than the multiplier that such investments generate in developed economies. What it means, according to the Economist, (http://www.economist.com/blogs/freeexchange/2013/08/fiscal-policy-developing-countries) is that infrastructure is one of the best investments these governments can make in their domestic economy.
When infrastructure investment is arranged through private investors, such as by using the increasingly popular Public Private Partnership model, the debt that goes into funding projects provides healthy long-term inflation indexed returns to investors. This makes it an ideal investment to match the long-term needs of pension funds, life insurers and even Sovereign Wealth Funds.
Investment Culture Matters
Domestically, investments of these kinds also reward a culture of saving over one of consumption, which can help to contain consumer price inflation and unsustainable current account deficits.
Another benefit to individual countries that comes from infrastructure investment is that the assets that are created boost the competitiveness of the overall economy. Projects can range from developing transportation links and energy distribution to building schools, hospitals or other essential infrastructure that serves the needs of the same public that ultimately owns the asset.
Finally, encouraging foreign investment in PPP can reduce the sensitivity of local asset prices to financial shocks elsewhere in the world, because the very long-term nature of these projects helps to “anchor” the flow of debt or equity within the country where the investment is made.
As competition for foreign capital continues to rise, it is certain that investable infrastructure will be among the asset classes that foreign investors will want to consider as they identify which emerging markets offer the best long-term prospects.