Financial crises strew wreckage in their wake. This is indisputable. Less acknowledged is that they also leave a positive legacy for those open-minded enough to seek it out.
This is hard to fathom right now given the goulash of crises bubbling around the world. Unquestionably, there is enduring damage being done. But by the same token, useful lessons are being learned. The end result should fuse Europe more tightly together than ever, secure a well fortified banking system, imbue governments with a fuller appreciation for fiscal prudence, and bequeath to policymakers a more sophisticated warning system to detect future crises and a larger toolkit to subdue them.
Emerging markets can certainly attest to this positive legacy, having gone through a similarly tumultuous period in the mid- to late-1990s with the Asian and Tequila crises. Developing nations took their lumps, but also learned their lessons, and have since radically revamped their conduct, reducing the risk of a sequel.
Collectively, developing nations have now dug a protective moat consisting of enormous foreign reserves, improved current account balances and low government debt loads. Their FX reserves have grown sevenfold over the past decade. Current account balances are persistently in the black. Government debt loads have fallen to just 39 per cent of GDP, a stark contrast to developed nations that sag under pendulous and growing debt ratios already more than twice as large.
All of this renders them less vulnerable to speculative attack, less reliant on volatile foreign financing and more capable of boosting their economies during times of stress. The proof is in the pudding: emerging markets have so far avoided a financial blow-up despite all that has lately gone wrong in the world.
To be sure, it is not entirely clear sailing for emerging capital markets. They are still connected to the outside world and treated as a risk asset, translating into inferior returns during times of global trouble. Equally, individual emerging market regions grapple with their own bugaboos, ranging from too much inflation, to overextended credit in China, to excessive reliance on foreign financing in Eastern Europe, to a dependency on high commodity prices in Latin America.
Yet these threats are nuanced. Inflation and food prices may be topping out. China’s credit splurge was partially at the government’s behest, and Chinese banks can in turn expect government resuscitation should their vitals weaken, even as the Chinese economy slows. External private sector liabilities are up, but with diminished reliance on short-term debt. Meanwhile, Latin American reforms make that region somewhat less exposed to another negative commodity shock.
By themselves, these threats still raise a near-term yellow flag, and could yet punish emerging market investments. However, when compared to the sustained tumult in the developed world, the outlook for emerging market economies over the medium and long term appears positively bucolic.
Not only have developed nations stumbled, but emerging market nations are gradually adopting the regulatory and institutional frameworks necessary for greater stability, deeper financial markets, lower inflation and rising wealth. In other words, many of the risks traditionally associated with emerging market investments are only transitory. For investors with a sufficiently distant investment horizon, these are developed market investments in disguise.
The combination of favourable demographics and ebullient economic growth rates remains the central charm of emerging market nations. A young citizenry and high fertility rates pay a demographic dividend in the form of modest government expenditures and a naturally expanding workforce. Meanwhile, developing economies have been feeling their oats, growing at a 4.8 per cent annualized GDP rate since 1970, almost twice that of their developed brethren.
The sector continues to enjoy a considerable length of unobstructed racetrack before it bumps up against developed-world levels of prosperity. The further out one goes, the tighter this superior economic trajectory should bind to investment returns. Amazingly, China’s economic output per person is no better than the U.S. was in 1935.
Developing nations now constitute over a third of the global economy, yet make up a far smaller share of Canadian investors’ portfolios. There is clear scope for expanded holdings on this basis alone, even setting aside the fundamental allures of the sector.
Emerging markets can no more guarantee a near-term investment “win” than any other asset class. But the emergent virtues of emerging markets render them an increasingly attractive investment option for the long run, so long as the risks are properly understood.
Eric Lascelles is chief economist for RBC Global Asset Management.
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