The emerging market party
By Scott B MacDonald

In early 1997, emerging markets were hot - spreads were tight, most Asian and Latin American economies looked robust, and investors could not get enough of Argentine, Brazilian and Indonesian securities. There were proclamations that we were entering a new era of economic sustainability in which most developing economies had reached the take-off stage to self-sustaining growth. Then came the ill-fated Thai baht devaluation in July. The Asian contagion swept through Asian markets, spreading through Eastern and Central Europe and into Latin America. The International Monetary Fund (IMF) was brought in to rescue South Korea, Thailand and Indonesia. Russia eventually defaulted on its domestic debt and made a disastrous devaluation. It took several years to recover.

It is now 2005. We are observing emerging market bonds trading at very expensive levels. Billions of dollars are pouring into emerging market equities. Even Argentina is drawing interest as the country's debt crisis is finally being settled and investors look over what is available to put money into (such as Telecom Argentina). Some are even proclaiming that this time the party will continue - that there is a new level of sustainability. But it is not that simple.

Emerging markets are not likely to experience any major meltdown in 2005. However, investors should be aware that while some countries have made significant progress and might be in a long-term take-off mode that implies sustainability of economic growth, a lot of other countries have not. Much of the current round of euphoria surrounding emerging markets comes from the commodities boom over the last two-three years. Higher prices for oil, natural gas, copper, nickel, gold and bauxite have stimulated economic growth and converted current account deficits into healthy surpluses in a wide range of countries.

Some countries have actually made a concerted effort to reduce debt - as with Russia. Others have made sweeping structural changes as in Turkey, China, India and Ukraine. Still others, like Mexico, have consolidated (at least for now) their position among industrialized countries. This overall positive trend is evident on the ratings front: in 2004 there were 30 upgrades and only 7 downgrades. The trend continued into 2005, with Russia, Mexico and India getting upgrades. There may be further ratings upgrades for Brazil, Chile, Indonesia, Panama (after launching an ambitious fiscal reform), and possibly Ukraine.

Despite the overall feel-good sentiment about emerging markets, the main concern is that the main force behind upgrades and tight spreads is cyclical factors. Countries like Brazil, the Philippines and Peru have high levels of debt and still have considerable need for further structural reforms. The fragile nature of emerging market economies was recently underscored by the IMF's Stabilization and Reform in Latin America report. The key points of the report were that weak financial systems were contributing to major economic crises in Argentina, Ecuador and Uruguay, and without further reforms regional financial systems remain vulnerable to contagion. In particular, many Latin American governments need to enforce stricter accounting and auditing standards, strengthen financial regulatory agencies and update bankruptcy laws. The IMF also noted: "Debt burdens in many Latin American countries are above prudent levels and must be brought down."

Although the IMF's comments were directed at Latin America, other emerging markets have similar problems. China's banking system remains a major challenge for the authorities, the Philippines is highly indebted and struggling to deal with a very messy fiscal situation, and many Middle Eastern and African countries continue to have considerable hurdles to implementing the right mix of economic reforms. In addition, there are political challenges - structural reforms are often unpopular, some national political elites continue to demonstrate a marked preference to loot their nations' wealth rather than spread it out, and non-formal political actors (such as terrorists and insurgencies) threaten the formal political system (as in Nepal, Sri Lanka and the Philippines). There is still time to make changes, however, which will make an even better investment story as a result.

At some point, the emerging markets party will come to end, but probably not in 2005. As long as international economic growth remains moderate, interest rates go up at a measured pace and investors remain hungry for yield, emerging markets are likely to enjoy further ratings upgrades. Emerging market equities will still attract foreign investors. Commodity prices are not expected to fall radically in 2005 and are expected to moderate downward in 2006. Certainly a crash in the Chinese economy, a massive dislocation in the dollar, or a major geo-political crisis could bring the party to an abrupt end. However, there is no sign of these at this point. Consequently, emerging markets look attractive in the short term, but in the long term we will see a big difference between those countries that have stepped up and made real structural changes and those that talk about it, but have instead enjoyed the cyclical upturn in the global economy without thinking ahead to the next round. As always, selection of the right securities is critical.

Scott B MacDonald is a Senior Consultant at KWR International

(KWR International Inc, a New York-based consulting firm specializing in research, communications and business development services for the public and private sector, with a special emphasis on the Asia-Pacific region. Visit the site.)