This post is the first of a series of four posts relating to emerging markets (EM). With commodity prices falling, the Fed likely to raise interest rates soon and investors spooked because of events in China, the recent EM sell-off has been painful. So while this post is topical, I have also been reading a very detailed and interesting book by Shalendra Sharma about the Asian Crisis in 1997. This has helped me understand some of the economic issues relating to EM investing and I am happy to share my knowledge on this topic. Many of the points that were relevant in 1997, remain important today. With this in mind, in this post I give a backdrop to EM investing and lay out the key macro items to consider.
On July 2nd 1997, the Bank of Thailand devalued the Bhat, sending markets into a panic. Fear spread across the region and across the World. The value of the Bhat fell by nearly 60% vis-à-vis the US Dollar over the next twelve months as foreign investors withdrew large sums of money. This set off a chain of events, not just in Thailand, but Indonesia, Korea, Malaysia, Philippines, Singapore, Taiwan and Hong Kong. Inflation jumped (due to higher import prices from weaker currencies), domestic stock prices fell sharply. Output dropped and unemployment jumped. In Indonesia, output fell 13.7% in 1998 after rising 8.0% in 1996 and 4.5% in 1997.
Governments used up large quantities of their foreign exchange reserves to defend their currencies. Most of this was in vain. Depositors withdrew their Dollar claims on local banks so Central Banks had to lend hard currency to prop up their domestic banks, depleting their foreign exchange reserves even further. To help stem capital outflows, Asian central banks raised interest rates to very high levels, but this obviously had the negative knock-on effect of raising the funding costs of solvent local companies and banks. And although higher rates offset some of the inflationary pressures from higher import costs, it has a massively negative toll on investment, GDP and employment.
Even relatively strong economies such as Hong Kong – which had regularly run current account and budget surpluses and had large foreign exchange reserves – suffered severely during the crisis. The Hang Seng index dropped more than 50% between July 1997 and August 1998. Hong Kong experienced massive selling pressure on its currency (which had been pegged to the Dollar like many other countries in the region) despite its local currency being fully backed by foreign currency (i.e. for every HK Dollar they printed, each was backed by a USD – unlike other countries in the region, I believe).
This raises the question as to whether this crisis was justified or not. Was it justified in some countries and not in others? Was there a market over-reaction? Did speculators exacerbate the problem? I think the answer to the latter is yes, although this is not unsurprising given the nature of markets. I think it is also fair to say that the crisis started for legitimate reasons (which I will detail further on), but that the herd mentality of markets lead to unjustified reactions and over-reactions in certain cases, such as Hong Kong.
In scary times, markets do silly things. So it is possible that by forecasting silliness, seemingly silly investment decisions may be perfectly rational. Capiche? This may have been the case with Hong Kong. Its currency came under speculative attack because of the following view: since Taiwan’s currency was falling and Taiwan competed with Hong Kong in many export markets, Hong Kong would devalue its currency too. It had no plans to do so, but the sustained (and unjustified) attack led to huge financial and economic costs for the country.
This problem with markets is nothing new and was described in 1936 by the brilliant John Maynard Keynes in his classic work The General Theory of Employment, Interest and Money. In that, he said “most of these persons [financial market investors] are, in fact, largely concerned, not with making superior long-term forecasts of probable yield of an investment over its whole life, but with foreseeing changes in the conventional basis of valuation a short time ahead of the general public…. They are concerned, not with what an investment is really worth to a man who buys it ‘for keeps’, but with what the market will value it at, under the influence of mass psychology, three months or a year hence”. This was still a problem in in 1997 and remains a problem today. It is even more acute for small, open economies such as Hong Kong where financial ‘speculation’ and ‘hot money’ flows affect the real economy: speculation can become a self-fulfilling prophecy.
Dealing with this issue is hard, which is why it remains problematic almost 80 years after Mr Keynes wrote about it. I do not propose a solution and am not ready to explain how to play the EM situation from an investors’ point of view. However, I can say that this is precisely why the IMF is so important. What happened in Asia in 1997 was the country equivalent of a domestic bank run. These are often unjustified and it is why deposit insurance and national central banks were created: to lend to solvent institutions that are experiencing liquidity problems (and thereby try to avoid financial panic). The IMF needs to do this at the international level, but there are a few very significant and challenging issues for it to consider: 1/ How does the IMF fund itself? (i.e. does it have enough money) 2/ How does it distinguish between solvent and insolvent countries? 3/ And how does it prevent moral hazard by providing a guarantee?
Note – my definition of moral hazard is the following: excessive risk taking because certain players can win in the good times but don’t pay the full costs in the bad times.
I will leave analysis of the IMF to another day, but I think it will have learnt lessons from 1997 and 2008. That said, fear is contagious and nearly all emerging markets have experienced large sell-offs in their currencies recently. Will this lead to a full-blow crisis, rational or irrational? I simply do not know and haven’t looked closely enough at the data (perhaps I will have an idea by the time post 4 comes along). But without further ado, let me get to the heart of this post: what were the problems with the Asian EM’s in 1997 and what are same the things we should look out for today. The list below provides a list of points, with a lot of overlap between them.
- Inadequate banking regulations
- Low capital requirements
- Loose lending standards (allowed lending to risky companies and individuals)
- Banks relied on too much foreign debt and short-term debt
- Crony capitalism
- Banks (sometimes state owned but also private) provide loans to inefficient corporations and for inefficient investment projects
- Implicit guarantees from the state for bank and corporate loans
- Creating moral hazard which leads to inefficient investment
- Poor corporate governance
- Politicians have business links with businessmen and bankers
- Operational link between banks and non-financial corporates (inefficient lending)
- Increase in leverage – households, corporations and governments
- Due to crony capitalism, implicit government guarantees, lack of regulation, etc
- Lack of fiscal responsibility
- Over-reliance on short-term debt
- Which would not be rolled over in times of stress
- Applicable to banks, governments and non-financial corporates
- Over-reliance on foreign debt
- Same problem as the point above
- In many cases this was combined with the problem of it being short-term in nature (and hard to roll over). Furthermore, it was also unhedged
- General lack of transparency
- Corporate accounts, regulations, laws, economic data, asset prices
- Related to corporate governance
Some of these are somewhat qualitative factors (such as corporate governance and transparency). Here are the quantitative economic factors that I would look at today. It should be fairly self-explanatory for each variable whether high or low values are desirable:
- Foreign debt levels
- public and private – financial and non-financial – short-term vs long-term
- Government debt (both in domestic currency and particularly in foreign currency)
- Fiscal balance
- Current account balance
- Foreign exchange reserves
- Total exports and exports excluding fuel
- Total imports and imports excluding fuel
- Reliance on commodities in the economy (qualitative assessment)
- Inflation
- Unemployment
- Wage growth
- Asset prices (real estate, equities, bonds)
- It is in bubble territory?
- Look at historical charts
- Look at conventional valuation metrics
- GDP growth
- GDP breakdown
- Over-reliance on certain industries?
- Investment
- Which sectors?
For all of the factors above, I would look at the absolute levels, share of GDP and the trends (growth rates).
I have not mentioned politics yet, even though this is perhaps the biggest and most important point for EM investing. I say this because politics can affect so many of the factors above, particularly in EM. Riskier countries are ones where a change in government might lead to significant changes in the factors above. The more politics can affect the points above, the riskier those countries are. And by extension, countries with stronger democratic institutions – e.g. judiciary, market regulators and central banks, etc – will perform better.
To reiterate, this post is about laying out a framework for EM analysis. I have detailed many of the factors that I would consider for EM investing. I have also laid out some of the history of the EM crisis in 1997. I do not opine (yet) as to whether this is likely to happen again. The risks are high at the moment due to a possible hard landing in China, coupled with a possible US rate rise. Both the World Bank and IMF have urged to Fed not to raise rates in September for fear of causing real disruptions to emerging markets. I doubt the Fed will seriously consider this request however. Its mandate is to consider the local economy and with new data showing that job openings accelerated to a new all-time high in July, the unemployment rate fell to 5.1% in August and GDP growth revised up to 3.7% in Q2, I’m starting to believe they could go in September. But that is a story for another day. Until then, enjoy the ride.
Note: these views are mine, and mine alone. They do not reflect those of my employer (past, present or future) or anybody that has or will pay me money. They are also subject to change, at the drop of a hat.