Tuesday, October 5, 2010

Strong Capital Inflow into Emerging Markets continues but the pattern changes

The Institute of International Finance (IIF) presented its semi-annual update on Capital Market flows to Emerging Markets. The IIF is an international membership organization of major banks from the developed and emerging world. For those of you interested in international capital market and economic research, we recommend a visit to the IIF website which contains interesting reports, forecasts etc. A nice alternative next to standard well-known sources like the CIA Factbook, the World Bank, the OECD or the IMF.

Net private capital inflows into Emerging Markets in 2010 are expected to reach $ 825 billion, up 16.4 percent compared to the estimate presented by the IIF in its April 2010 issue of this report. Compared to the inflow for 2009, $ 581 billion, it is an even more remarkable growth. The growth pattern is the result of a combination of 
a) Strong fundamentals in Emerging Markets  
b) Continued weakness in Mature Markets in the aftermath of the Global Crisis.

The strong relative fundamentals vis-a-vis the Developed Markets can be expressed by the differential gap in expected GDP growth. At the moment expected GDP growth in Emerging Countries is expected to outperform that in Developed Countries by 4.4% per annum. If we add to this the fact that Emerging Countries have stronger foreign reserves positions, lower debt-to-income ratios and a structurally better economic position when looking at the more distant future, the strong continued inflow of foreign capital is not so surprising.

 Emerging Market Growth; More than BRIC Alone

When analyzing the components, it is clear that the inflow of Official Money, i.e. aid-related financial flows, and Bank Loans have become less important. Actually with respect to the former component: support to weaker countries within EU (i.e. within the Developed World) was so big that this aid-related element is not the prerogative of emerging, needy economies anymore. To illustrate: official, formal support for Greece was larger than what was awarded to Thailand (the maximum until now) in 1998. The support package for Greece is calculated to add up to approximately 35-40 percent of GDP! Other countries in EU (Portugal, Ireland, Spain) are also in danger, but they did not yet get any official, formal support. 

This implies that the two components that are responsible for the increased flows are
i) Portfolio Investments; and
ii) Foreign Direct Investments (FDI).
This is a good sign, because these two components are relatively more stable than the afore-mentioned two. This will further help reduce the risk of Emerging Markets investments. Although FDI flows are still the most important component in absolute terms (40 percent of the total), growth in Portfolio Investments was far more spectacular. Regions benefiting were Asia, Latin America and to a lesser extent - but still substantial taking into account the relatively smaller financial size of the region - Africa & the Middle East. In Eastern Europe flows were stagnating a bit, mainly due to disappointing results in Russia. However, first indications are that Eastern Europe is seeing some improvements as well, which might further materialize in 2011.

Equity Investors going Global
With Global now including EMs

Interestingly, the area within Portfolio Investments that benefit more was Equity Investments. But LMG Emerge believes that Emerging Market Debt investments will also get more attention over the next 12 months due to the fact that the combined effect of continued low interest rates in Europe, the USA and Japan and the potential for currency appreciation in Emerging Countries will make EMD on a relatively basis a more attractive sub-category within the asset class Fixed Income. The foreign flows into Emerging Markets Equities were mainly targeted at large caps. Not only through acquisition at local exchanges, but also with foreign investors participating in seasoned equity issues of large firms. A clear example is the fact that of the Petrobras issue in Brazil $ 18 billion went to foreign investors. This represented slome 25 percent of the total portfolio equity inflow into South America! There were no real big surprises when looking at the markets that seemed to have the biggest traction: China, India, Brazil, Argentina, Peru were leading the pack in Asia and Latin America. Money inflow into the Russian and Ukrainian market was mainly offshore money return home. Within Asia and the Middle East South Africa and Egypt pulled in most investor money with reluctance about Dubai still continuing.

Within the FDI component the results corroborate information that LMG Emerge derived on a more ad-hoc, anecdotal basis. The findings of the IIF confirm that FDI by companies headquartered and domiciled in Emerging Countries is growing tremendously. A large part of this is going to other Emerging Countries, partly because of their interest in stakes in extraction industries (commodities, energy), food industries and construction and logistical operations. But it is also still the result of difficulties encountered by Emerging Markets investors when trying to do M&A's in the Western World. Very often indirect ceilings are raised because of alleged strategic issues. We believe that with ongoing weakness in Western countries and continuing strength in Emerging Markets this factor will gradually deteriorate in importance. This will also be directly related to the extent to which governments in Emerging Markets will give their leading entrepreneurs more freedom to act.

LMG Emerge believes that privation and governance improvements will not just continue because of longer-term trends in this direction at a global scale. We believe that Emerging Country governments will also understand that it is one of the best ways to reduce the pressure on their currency, to the extent that they are unwilling to opt for the alternative mechanism of strong currency appreciation. Most of the leading Emerging Markets economies are to a large extent export oriented. We do not believe that this will change any time soon, notwithstanding the fact that domestic markets provide a stronger home base now. Domestic growth will continue giving big Emerging Markets companies a fantastic starting point. Stimulation of their activities abroad in combination with even more international portfolio investments by its residents will reduce pressure on the currency, thereby creating a situation in which these firms will be strong players on the M&A markets in the years to come.

Bank lending by Western banks to Emerging players will obviously sooner or later recover, when this borrowers further improve their financial strength vis-a-vis Western borrowers, but according to IIF continued growth in portfolio investments and FDI will remain more important. At the moment IIF predicts that inflow levels for 2011 will be slightly higher than the new forecast for 2010, but the last 2 years the organization was all the time too careful with its estimates that had to be revised upward with all updates. LMG Emerge is slightly more optimistic: we believe that net inflow levels will probably reach $ 900 billion in 2011.

Investors who want to use the information for their investment strategy are advised to be careful not to jump on any bandwagon too late. Growth in market flows in Asia and Latin America shows that momentum here is already under way. And the good fundamentals will not necessarily translate into a further increase in valuation ratios that are already high. New issues - compare the Petrobras example - will also help reduce upward pressure on share prices with growing numbers of firms (and governments - think about privatization schemes!) trying to get their share of the action. The probability of paying too much will then increase. We believe that the best chances lie in Africa and the Middle East (especially equity investments) and even in Eastern Europe. In the latter region the financial fundamentals are still tricky. A lot of local banks are busy repaying Western banks after receiving huge amounts in the period 2004-2008. Local economies are struggling, but valuation levels have come down tremendously in comparison to other Emerging regions. We believe that the region will become attractive again for FDI by Western firms that want to expand their interest. In combination with a large need for more and higher quality real estate projects this translates into Property being one of the safer more attractive asset classes in Eastern Europe. We remain careful about Russia but are more willing to consider an investment in Eastern European Property (diversified country mix) elsewhere, especially when incorporating Turkey in this group. We believe that Eastern Europe will increase its role as 'cheaper labor' block of Europe.

A couple of days ago the Economist published an article about the brain drain from Latvia to Russia and the British Isles. We agree that what happened in this Baltic state could be a risk elsewhere in Eastern Europe, but the bottom-line will remain that Western Europe and European firms have an interest in expansion of their activities in the still cheaper and geographically close Eastern European markets. Activities in countries like Poland, Czech Republic, Slovakia, Slovenia, Romania and Turkey might benefit. Starting with Property as a collateralized asset with lower risk than equity (but without current low-interest rate related risks that plague regular fixed income) might be a good choice.


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