As emerging markets faltered, André Bourbonnais went shopping.
Despite the trouble ripping through fragile economies from Argentina to South Africa, Mr. Bourbonnais, who oversees private equity holdings for the Canada Pension Plan Investment Board, figured now was as good a time as any to place a specific bet on a particular region.
On Friday, after a week in which other investors pulled nearly $10-billion (U.S.) from emerging economies, CPPIB announced that it paid $200-million for a new 10.4-per-cent stake in Peruvian natural gas transporter Transportadora de Gas del Peru SA (TGP). Mr. Bourbonnais said his investment represents the cornerstone of a long-term partnership to pursue infrastructure deals in select markets in Latin America, underscoring the group’s belief in the long-term potential of certain expanding economies, such as Brazil and China – despite the turmoil in a number of other developing countries.
“We’re long-term investors,” he says. “We understand there are going to be cycles, and we need to be a little more prudent in terms of uncertainty, but clearly we’ll continue in emerging markets.”
The upheaval is widespread. Currency is being devalued in Buenos Aires. Strong growth in Brazil has waned, and the Turkish lira has plummeted. In South Africa, an ailing economy is mired in miners’ unrest, and in China slowing growth is endangering commodity exporters that have been riding the cyclical boom.
Already, the chaos has wiped $1.7-trillion from global stocks, hurting investors and forcing a re-examination of emerging markets, now sputtering and deemed riskier, endangering global growth.
But these countries are not united by similar problems, such as the bad loans and deficits that led to the 1997 Asian financial crisis. What’s happening now is a decoupling of emerging markets from one another that economists suggest is long overdue.
As the tide of capital flows out from a credit boom fuelled by easy monetary policy in the developed world, emerging markets will be revealed either as longer-term winners whose fundamentals remain secure, or shaky, vulnerable economies whose leaders squandered the opportunity to implement meaningful reforms in boom times and will pay the price. And while there is still a risk of contagion, the crisis may also create opportunity for Canadian investors such as the CPPIB.
After years of growth fuelled by the BRICS countries – Brazil, Russia, India, China and South Africa – emerging markets are being battered. The U.S. Federal Reserve’s pullback on its massive stimulus spending – underscored with a further reduction, or “tapering,” of its bond-buying on Wednesday – and slowing growth in China has caused investors to pull out of riskier countries and seek safer returns in the United States.
“In and of itself, the Fed tapering should not have been such a big deal. But it was a big deal. It forced a re-examination of the world economy in general – and emerging markets in particular,” says Edwin Truman, who served as assistant secretary of the U.S. Treasury for international affairs and was on the G10-sponsored working party on stability in emerging-market economies during the Asian financial crisis. “The difference here, which is sort of good, is this is not Latin America alone, or Asia alone. It’s not regional. It’s sort of various emerging-market countries around the world. And they each have their own little story.”
As things turned sour, India’s central bank was the first to strike back. Then came Turkey, followed swiftly by South Africa. One by one, central banks of large but fragile emerging markets raised benchmark interest rates as capital outflows from emerging-market debt and equities reached $9.1-billion, according to Merrill Lynch – which estimates that roughly $15-billion more could be pulled out in coming weeks.
Turkey’s hike was as aggressive as they come. The central bank in Ankara gave a jolt of 4.25 percentage points, raising the overnight lending rate to 12 per cent from 7.75 per cent and leaving some worried that Turkey may have run out of firepower. In South Africa, which has been hurt by falling commodity prices and suffered from numerous mining strikes, the central bank unexpectedly raised its repurchase rate to 5.5 per cent from 5 per cent, the first increase since the depths of the global financial crisis in 2008. The magnitude of outflows from emerging-market debt and equity funds, as measured by Merrill Lynch, rival those during the collapse of Lehman Brothers.
Just how bad is this crisis?
In the mid-1990s, John Darch thought he had struck a potash bonanza in a remote corner of Thailand. The Vancouver-based mining investor had lined up local Thai partners and was planning to push ahead with a mine in the country’s northeast. Southeast Asia was booming and the mine would have enabled them to ship potash to other so-called Tiger economies, which had been growing at an annual pace of about 8 per cent for the previous decade. “It was a bubble waiting to happen,” Mr. Darch recalls.
What came next was the Asian financial crisis. As the chaos engulfed Southeast Asia, his partners’ financing dried up and Mr. Darch’s dream became an early victim of carnage that would crush currencies and claim banks and brokerages from Jakarta to Tokyo. Because what was happening in Thailand was only the beginning.
The trouble spread quickly from a localized crisis in a Thai bubble economy fuelled by bad loans, leaping to Malaysia, Indonesia and the Philippines. It eventually hit South Korea, a country with few of Thailand’s problems. Countries spent billions to defend their currencies before giving up and devaluing. International investors pulled out and ran for safer markets, while the International Monetary Fund lent tens of billions of dollars to stabilize plummeting currencies. The Brazilian and Russian economies tanked the following year.
“I’m sitting on my hands for now, and that’s what I’d recommend others do,” says Mr. Darch, who runs a sustainable coffee business in Thailand as he pursues other mining licences. “If you’re going to invest, I’d stay away. But if you’re already there, then just sit tight.”
At the same time, Mr. Darch says you can’t compare then and now. Others agree. That sort of contagion has not yet happened.
Although united by the fallout from the Fed’s tapering, economists say these countries suffer from mainly unrelated problems, and that investors can see this as a turning point in how to view emerging markets.
“It’s not 1997. Back then, the crisis for emerging markets was they all had similar vulnerabilities,” says Neil Shearing of Capital Economics in London. “Whereas you used to be able to lump emerging markets together as one single homogeneous entity, you can’t do that any more.”
The current troubles are remarkably uneven. In India, slowing growth is laying bare government economic reforms yet to be implemented. In Argentina, economists worry a decade of economic mismanagement and a hastily devalued currency may precipitate a recession. In Turkey, a corruption scandal has led to cabinet resignations while the head of a state-run bank was arrested on graft charges. And in South Africa, falling commodity prices have slammed mining companies and led to violent protests. Hardly uniform problems.
In 1997, countries at the heart of the trouble mostly had fixed exchange rates, little to no reserves, and had coasted on a credit boom that fuelled bad loans and papered over the lack of meaningful economic reforms. They also all had large currency mismatches, in which a country’s residents are not adequately hedged against sharp changes in the exchange rate – a fixture of numerous financial crises in emerging markets.
Now, particularly in Asia, that’s not the case, according to Rob Simmons, who took over as Asia-Pacific regional manager for Export Development Canada in 1997 as markets tanked, and who now heads Alberta’s trade and investment office in Singapore. Exchange rates are more flexible, reserves are much more robust, there are a number of reserve-sharing mechanisms between central banks in the region, according to economists, and there is a lingering wariness about risky investments, particularly in real estate.
“Back then, it was building after building going up in Bangkok,” Mr. Simmons says. “Now, that’s not happening as much. Memories are long in Southeast Asia. Banks, government and investors remember what happened in 1997.”
While many investors are pulling out of emerging markets in general, some of Canada’s biggest players are selectively staying put in particular places – highlighting the varied potential of different emerging markets. Leo de Bever, chief executive officer of Alberta Investment Management Corp., which invests $70-billion on behalf of Alberta public sector pension funds, said the sweeping downturn across markets presents a great opportunity to invest in stronger countries caught in the stampede.
“We obviously will use this as an opportunity to distinguish between sectors – and countries, in this case – that are likely to be hit less,” he says.
“We don’t have much sympathy for a place like Argentina, but we obviously have a soft spot for Chile,” where the fund has big investments.
“And we like countries like Peru and Colombia because they are trying to follow in the footsteps of Chile.”
Brookfield Asset Management, which invested in U.S. shopping malls during the financial crisis of 2008, has $21-billion of assets in South America. “Economic growth can be uneven, and political shifts are occasionally dramatic,” Brookfield Asset Management CEO Bruce Flatt wrote in the firm’s third-quarter letter to shareholders. But still, he added, “we believe in the long-term potential of emerging markets.”
And CPPIB has taken a huge bet on the potential of fast-growing regions, investing over $17-billion in emerging markets as of March 31 last year. The fund argues that the world’s centres of economic and demographic power are shifting to countries with higher economic growth rates such as Brazil, China, India, South Korea and Indonesia, and in coming decades they will become the world’s best investment markets.
Michael Wissell, senior vice-president of public equities at the Ontario Teachers’ Pension Plan Board, says recent turmoil has changed nothing about Teachers’ investment strategy in emerging markets, where it owns companies in countries such as China, Brazil and Chile.
He said lower prices may also create opportunities for deals on good assets, especially if the drop is overdone in certain markets. Teachers is particularly committed to Asia from its base in Hong Kong, he says, and believes there are long-term opportunities in markets such as China. “We’re believers in that area and we’re there for the long haul, and we expect to be there for the long haul. We have lots of assets listed in emerging economies, and I would wager a guess that many years from now we’ll still have many of those assets.”
Winners from the losers?
Still, the speed with which events are unfolding is catching many by surprise. While Argentina was devaluing its currency and protests were growing increasingly violent in the Ukraine, Mr. Simmons was meeting in Singapore with various Canadian and Singaporean bankers. “A number of the banks came in and said what’s going on in the Ukraine? With the chaos in Thailand? They were following it hour by hour,” he says. “The people that I talked to hadn’t seen anything like this in a while. And they hadn’t anticipated all of these things happening at once.”
That can make it difficult to separate winning emerging markets from those with deeper problems.
One way is figuring out the degree of exposure to two of the biggest current events in the global economy: One being the U.S. taper, the other being China’s slower growth. Mexico, for example, is closely linked to the recovering U.S. economy and manufacturing, while commodity-exporting Indonesia has significant exposure to developments in China.
Another thing to look for is ballooning current account deficits and low reserves of foreign exchange, two things that unite Turkey and South Africa, says Capital Economics’ Mr. Shearing – who also names Chile, Peru, Thailand and Brazil as countries to watch carefully for signs of the troubles spreading further. On the other hand, the Philippines has run a current account surplus every year since 2003, allowing its central bank to keep interest rates low in order to encourage growth. India, though it narrowed its high current account deficit by banning gold imports, is nevertheless heading into an election – like both Brazil and Turkey – that has prompted concerns of policy paralysis at a time when economists say slowing growth requires substantial economic reforms.
For Razia Khan, an economist who monitors the fast-growing economies of Africa for Standard Chartered Bank in London, there is also optimism. “We seem to be caught up in the eye of the storm now, but there is no realistic expectations that this is going to be sustained,” Ms. Khan says. “The reasons why we were positive about emerging markets two or three years ago have not changed.”
Yuen Pau Woo, who heads the Asia Pacific Foundation of Canada, says chaos in emerging markets represents an opportunity for investors to re-evaluate the entire category. “I would love for this to be a turning point in how people think about emerging markets, not lumping them into one big basket of common traits,” he says. “And with China in particular being the most unique and distinctive of them all, not even being deserved to be called an emerging market, but a standalone driver of global growth with its own problems and challenges.”