Situational Assessment and Outlook of Investments in the Emerging Markets

By Syed Sheraz

Emerging Market Crisis (Covered by Financial Times)

The investment community is currently facing a pivotal time, where their strategies are being tested and challenged every day to the point of financial ruin and future prospects of their monies are yet to be determined. And at the center of this all is the financial crisis in the emerging markets, which for the last few decades have been the center of economic growth in the world, but are now declining. Emerging markets have at times represented the biggest appreciation of stock value (2000 to 2008) and at times been at the scene of wealth destruction (2008–2009). These concerns are further compounded by the illiquidity (lack of trading volume) and lack of instruments for hedging market risks, all of which scares any confidence out of an investor (Saxena & Villar, 2010). Illiquidity can cause the uncertainty that invested money would not be able to be taken out at a later time, while market risks (such as flash crashes) add on the investor’s uncertain outlook of the market. The uncertainties are further compounded by the despised heavy-handed interventions and market manipulations by the central authorities in the emerging markets.

Definition of the Crisis in Emerging market. Emerging markets consists of developing countries such as Russia, China, Brazil, India, South Korea, and Philippines amongst others that represent most of the economic growth of the world over the past few decades. Their growth has been unequivocal overtime; however, recently equity markets in China, the largest emerging market, has lost close to 40% of its value over the past four months, and many people have lost fortunes in the process.

Government intervention and manipulation. It’s no surprise that the equity markets of especially autocratic countries like China face high levels of government intervention and manipulation. When the economic situation is not agreeable to the Chinese government’s desires, they can come out with some heavy-handed efforts to fix the problems. Major investors, such as Li Yifei, have been harassed by government authorities and have been told to hang on to investment no matter the cost, or face consequences (Wong, Gough, & Stenvenson, 2015). Bloggers and media players who have been critical, in any way, have been officially scrutinized and detained (Wong, Gough, & Stenvenson, 2015). As such, China’s government is creating a hostile environment for trading, where traders are uncertain if they will be able to pull their assets out of their investments, if the market were to go south (Wong, Gough, & Stenvenson, 2015). Adding to that is the major uncertainty in the market is the extent of slowdown in China’s export-centric economy, which has been the main influence on downward force on the stock market.

Even to start, China carries an “investment-heavy model” of investment where all the investment decisions come from the central government (Schuman, 2015). Their government seems to adhering to its age old approach of governing though central planning where the government decides who keeps their investments where. Such top-down investment strategy is quite heavy-handed as well as archaic. And market manipulation at such level, in any understanding, cannot end well for the market.

The principles of market economy is that the market, made up of traders and investors, decides which corporations and companies they want to invest in. These traders and investors look at the fundamental and technical performance of these corporations and companies for their valuations. The stronger corporations and companies will have their stocks rise in the stock market as they continually show strength in their earnings, while the weaker will have their stock fall. This is how the market works, and it proposes that good investing is investing in corporations and companies which show fundamental and technical strength.

But recent actions of Chinese authorities, seem to show that they are criminalizing good investing. The authorities would rather have investors and traders stick with their stock and never sell it even if the companies are not performing (Wong, Gough, & Stenvenson, 2015). Furthermore, the government has put bans on short-selling, which is an important tool in the hands of traders to manage risk (Wong, Gough, & Stenvenson, 2015). Without short selling, investors are shorthanded in making sensible trading investments.

Short selling is the core tool used by investors and traders to hedge their portfolio against market risks and other risks. In a short-sell, a trader will borrow stock from someone and sell it to someone else with the motive that if the stock price were to go down, they would net a profit. It is the opposite of buying stocks, aka going long on stocks, which will net a profit if the stock price were to go up. Although short selling alone can be risky investment, but when coupled with going long on stocks as well as future options and derivatives that can be more complex, can create a competent investment strategy (Wong, Gough, & Stenvenson, 2015). Investors need tools like short-selling, future options, derivatives, index funds and volatility indexes to create a resilient investment portfolio. And as it is happening in China, investors are only told to buy stocks and hang on to them no matter the market trajectory (Wong, Gough, & Stenvenson, 2015).

Good investing relies on hedging and risk management, done through tools like short-selling, future options, derivatives, index funds and volatility indexes. These tools safeguard investors and traders, which prompt them to fully invest all of their assets without anxiety because they can manage their risks. When all traders and investors can trade without anxiety, the market becomes more liquid (more trades go through the market) and the market goes up. The market becomes increasingly healthy and adaptive to temporary setbacks (such as the one China may be facing right now) when risks can be adequately managed. And everyone is happy.

The heavy-handed actions of Chinese authorities seem to discourage investors and put them in further uncertainty and fear, which will only cause more trouble in the market. It is about time China enters the modern era, and let market forces make the market decisions, rather than inexperienced government employees, and allow modern market tools such as short-selling, future options, derivatives, index funds and volatility indexes, to empower their investors and traders. Otherwise, their decisions may cause the collapse of emerging markets.

Hedging to reduce investment risk. Investors in the emerging markets critically need hedging instruments to safeguard themselves, which to any understanding will give them the confidence to fully invest all of their assets because they can hedge their risks. The market, thus, becomes more liquid as more investors trade and become healthy. The goal of most government authorities in emerging market counties is to enable this dream of healthy trade (Wong, Gough, & Stenvenson, 2015).

Derivatives are tradable financial assets that do not have any underlying tangible assets (such as a company or corporation). Their value is instead derived from stocks (which might have tangible underlying assets) and indexes (a group of stocks) that are packaged into a financial instrument that can be traded. Building instruments to trade derivative of market assets allows investors to trade risk, including domestic market risk, global market risk, industry risk and commodity pricing risks (Saxena & Villar, 2010). Broadly, the derivatives market defines the opportunity to manage portfolio risk for investors and gives them the confidence to readily invest (Schuman, 2015). The derivative markets include the foreign exchange market and the local currency bond markets (Saxena & Villar, 2010).

The foreign exchange markets in the emerging economies allows the trade of assets of local assets across international borders and thus spreads the risks of the local asset across investors across the globe (Saxena & Villar, 2010). The emerging economies’ foreign exchange markets has grown from $98 billion in 2001 to $246.9 billion in 2007, while also representing massive market growth and trading transactions and volume (Saxena & Villar, 2010).

The local currency bond markets trade the local government’s treasury bonds and notes on the global scale. All governments have a risk of defaulting on their bond issuance when they go bankrupt, which means that some local governments pay higher bond rate (interest rate) on their bond issuance to make their bonds an attractive investment (Saxena & Villar, 2010). Currency bond markets are able to distribute the defaulting risk across the global investor population who would be interested in investing given the risk profile (Saxena & Villar, 2010). The currency bond markets has growth from $1 trillion in 1998 to $4 trillion in 2010, while also providing increasing yield curves (Saxena & Villar, 2010).

Derivative instruments have been growing in the emerging markets across the board in all asset and derivative classes over the past few decades (Saxena & Villar, 2010). These include foreign exchange markets and local currency bond markets, that provide instruments like swaps, forwards and options, most of which can be quite complex to understand. These market tools have seen dynamic growth in their use, which suggests that their use will continue to increase in the emerging markets to enable proper risk management and liquidity in those markets. It looks to be that outside of China, derivative market is amply growing to build a strong healthy emerging markets.

Healthy Trading of Derivatives. Derivatives market trading have considerably increased emerging markets over the past decade. The daily turnover rate, which defines the percentage of GDP of the overall economy that is traded daily, stands at 6.2% ($1.2 trillion) for the emerging markets, increasing more than 300% since 2001 (Mihaljek, 2010). The number is still low compared to advanced economies that stand to 36% daily turnover rate ($13.8 trillion) (Mihaljek, 2010).

These derivatives are traded in emerging market economies to hedge and speculate against equity market risks, foreign exchange (currency) rate risk and interest rate derivatives (Mihaljek, 2010). Although foreign exchange account for the larger share of these derivatives, equity market-linked derivatives, which are tradable financial instruments that derive value from company stocks, are increasingly being traded more (Mihaljek, 2010).

Interest rate derivatives are highly traded in Brazil, a country that has massive problems with inflation. Because of their economic situation (that causes foreign exchange rate to rapidly fluctuate), interest rate derivatives account for more than 60% of the derivative market (Mihaljek, 2010). Other emerging markets are more contained with steady foreign exchange rates (Mihaljek, 2010).

Based on the collected data of financial institutions, some insightful correlations can be drawn with daily turnover rate of derivatives against three independent variables: exports & imports, financial openness and bonds outstanding (Mihaljek, 2010). All three show positive correlations, which means that when each of the three increase (exports & imports, financial openness and bonds outstanding), daily turnover rate also increases for the economy (Mihaljek, 2010). Out of the three, financial openness displays the best correlation (beta = 1.0431) (Mihaljek, 2010). This is really important factor, to consider, especially in the case of China, the largest emerging market economy, that has recently been restricting its financial markets from trading in derivatives (Wong, Gough, & Stenvenson, 2015). If it continues in the direction, it might be doing more harm than good to its financial markets in the long run.

Separate but related situation in Brazil. Brazil has continued spiral down to economic oblivion over the past few years. Rapid inflation has been devaluing the nation’s currency, while broad depression has been devastation the nation’s industry (Snider, 2015). But for once in a long time, the country fared well in reversing this trend when the central bank renewed its promises quantitative easing (Snider, 2015). However, the central bank has done a lot over the length of this economic crisis without any promising results (Snider, 2015).

Ever since April of 2013, the central bank has been shorting instruments in foreign currency in order to stall the currency devaluation of Brazilian Real (Snider, 2015). Up to today, Brazil has steadily increased this short position, currently standing at $104 billion, out of its $371 billion total foreign reserves (Snider, 2015). That is a huge number, and despite such huge steps, the central bank has been unable to put a hold to the falling currency and economy (Snider, 2015). There are still $271 billion left that the central bank can still use to stimulate the national economy (Snider, 2015).

Most investors and stakeholders are continually asking for further central bank support to stimulate the economy and the central bank has been continually holding auctions of currency swaps, dollar repurchase agreements and local debt over the course of this crisis (Snider, 2015). These central bank intrusions have helped a little, by reducing fluctuations in the market, but the overall trend has continued to be downwards (Snider, 2015).

The same failed policy will not help with this crisis and maybe hard reform is what is needed at this point to knock the economy out of this downward spiral (Snider, 2015). Considering the Brazilian central bank might have some resources for now to continue with the financial support of this economy, but it just doesn’t have enough financial reserves to continue this policy of financial stimulus. Sooner or later it will need to take hard steps.

Desperate but salvageable situation in China. The biggest of the emerging market economies, China, is not doing so well (Consulting, 2015). Their growth is close of zero percent and their consumer consumption is still low even as the investments of the people are going down (Consulting, 2015).

Because of the widespread manipulation of financial institutions by authorities, the official statistics that are released by the Chinese officials cannot be trusted (Consulting, 2015). Their statistics give a highly misleading picture, and show that China is recovering, while leading third party statistics is showing otherwise. The China momentum indicator has fallen to an all-time low of 3.0% on an annualized basis recently (Consulting, 2015). This gives a gloomy picture for the Chinese economy.

On top of that, The China railway freight and China electricity production also see huge dips foretelling the weakness in the economy (Consulting, 2015). These numbers give a good predictor of economic recovery because these numbers will jump when the factories are doing well and when the economy is growing. We just don’t see this when the numbers are decreasing.

The China nominal bank loans have also shown a decrease in growth over the past few months, showing that businesses are not requesting funds that they could use to grow (Consulting, 2015). Instead, we can safely say that the businesses are reducing investments and possibly reducing output to save cash, when demands for the products are slowing down. This slowdown is demands is shown by the decrease in consumer goods import, that decreased by 4% in the last twelve months (Consulting, 2015).

The main indicator to look at the consumer consumption, which in the case of China has fallen over the past few years. Despite this, the investments in the country’s stock market have been increasing (Consulting, 2015). This is not a good sign because it tells that the market is overvalued. When the consumer spending decreased in 1960s and 1990s, the Chinese stock market took the tumble with it (Waite, 2015). Credit contraction shown by huge capital outflows from emerging markets, sharp market downfall in most of the emerging markets, and signs of slowing and market volatility suggests that this crisis could be the same as the major emerging markets crisis in 1997 (Waite, 2015). Maybe, from the intervention and manipulation from the Chinese authorities, the market might stay stable, but sooner or later, it will fall because of these fundamentals.

Some say that actions of Chinese authorities stopped larger financial collapse. No one can be sure, but there are claims that China market manipulation might have saved the day. In the face of a crisis, the Chinese authorities instituted a macroprudential policy that is regularly recommended by economists, but never implemented in developed countries (Frankel, 2015). They instituted monetary easing since last November, and provided positive outlook and encouragement in state media to boost morale (Frankel, 2015). They also tightened requirements in margin and facilitated short-selling (only by expanding the number of eligible stocks) (Frankel, 2015). Their intervention, according to some sources, seem to be innocuous and the real blame is really the fundamentals of the markets (DeFotis, 2015). High debt and decreasing growth is not a good combination and that is exactly the root of the problem in emerging market right now (DeFotis, 2015). China and South Korea are sailing that ship while Brazil, South Africa, India, Mexico and parts of Central and Eastern Europe might be able to rescue themselves since they are still yielding high growths (DeFotis, 2015). The situation is grim, but not yet a complete catastrophe if the preceding statements turn out to be true.

The prediction for the upcoming years is that the stock market will shrink a bit, but they will slowly recover in the next few years (Consulting, 2015). The market has already tumbled 40%, and just a little further drop will make the Chinese market fairly valued. The prospects are then that it’s still risky to invest in the Chinese market because there is little upside. But despite their massive market manipulation and intervention which to most seem hurtful (some arguably oppose that), in the next few years, China will again become the economic growth powerhouse that we have known it to be.

Investing directly in emerging markets may be risky, but indirect investments should be safe enough. There are two considerations to take on that account before investing in the emerging markets: investing directly or investing through American companies (Ermlick, 2015). Investment advisors are strictly recommending against investing directly in emerging markets since most of these countries have totalitarian governments and a lot of corruption and fraud, and it is highly unsafe for an individual to keep their investments there, since there are no oversights and guarantees (Ermlick, 2015). Now, investing through the American companies that operate in these areas of the world, thus collecting on the high growth seen in these areas of the world, is a lot safer investment for an American (Ermlick, 2015).

The biggest problem facing the Chinese economy is cultural. Being a communist country with still in power communist governing authorities, the Chinese economy has a long way to go before they can institute a fully operational free market (Ermlick, 2015). A lot of market progress currently seen in China can be attributed to Hong Kong, and went China got it back in the 1990s (Ermlick, 2015). That is not enough, China needs a lot of market reforms, and it needs it soon. The dissolution of Soviet Union in 1990, and what followed was a boom of the Russia stock market (Ermlick, 2015). Because of restrictions on investors and corruption, Russian economy has been suffering and their market is not doing well (Ermlick, 2015). The same thing could happen to China.

Investing in Russian Stocks was a good idea when their economy was growing, maybe investing in the Chinese broad market Stocks might have been safer at one point in the last few years, but after the last few months no one can be sure what will happen with the Chinese economy (Ermlick, 2015). As a matter of fact, these Stocks, both Russian and Chinese, showed a 35% return each year for a time year time period, showing you just how good of an investment they were (Ermlick, 2015). Not anymore, especially considering the restrictions that China has been imposing on funds in the country (Ermlick, 2015).

Emerging Markets Outlook (Covered by Financial Times)

Conclusion. On one hand, the emerging markets seem invincible, standing on the crown of their past success and growth and promising to only lead to even higher lands, but on the other hand, they seem to be crumbling, collapsing under the weight of their weak foundations, rampant corruption and governmental manipulation in the financial sectors. Good analysis is vital in this case (when dealing with the topic of investing in emerging markets) as the opinions of financial analysts will be harbinger of success or failure in the emerging markets. As the analysts are the experts, their words would easily be a self-fulfilling prophesy since if they persuade that emerging markets are a hollow construct, then capital inflow will surely withdraw and emerging markets will fail to develop and instead collapse. So the stakes are high on this assessment as it could easily determine the future success or failure of emerging markets. Likewise, the financial success or ruin of individual and institutional investors in the emerging markets is also at stake here since it is on their capital that will be enabled to grow and develop, and they in return will reap the fruits of their prudent investments.

Emerging markets, including but not limited to Russia, China, Brazil, India, South Korea, and Philippines represent the growth engine of the world economies. Over the past few decades, most of the world’s wealth was generated over there and only until the last few month’s they were growing at the rates of 20% a year, almost unimaginable in the developed world. Most of the developed world today has been pretty stagnant in the past five years, while the emerging market has been the only source of growth to the world in the meantime. Emerging markets will continue to represent the highest tier of growths in the world.

The derivative markets and hedging are also growing healthily in emerging markets, despite recent heavy-handed market interventions and manipulations in China, which means that the market is heading towards a more efficient form in the long run. Some say that Chinese market manipulations might have been healthy, but most analysts agree that they are hurtful. In general, the immediate future looks bleak for the emerging markets and soon the emerging markets will once again show decent growths.

References

Consulting, F. (2015, 10 02). China’s Slowdown Could Have Much Further To Go. Retrieved from Seeking Alpha: http://seekingalpha.com/article/3548796-chinas-slowdown-could-have-much-further-to-go

DeFotis, D. (2015, 09 25). Goldman: Fear Emerging Market Fundamentals, Not Fed. Retrieved from Barron’s: http://blogs.barrons.com/emergingmarketsdaily/2015/09/25/goldman-fear-emerging-market-fundamentals-not-fed/

Ermlick, D. (2015, 10 01). Regional Sales manager, CFA. (S. Sheraz, Interviewer)

Frankel, J. (2015, 09 07). In defence of Chinese market interventions. Retrieved from The Guardian: http://www.theguardian.com/business/2015/sep/07/chinese-market-interventions-yuan-stock-markets

Mihaljek, D. (2010). Derivatives in emerging markets. BIS Quarterly, 43–58. Retrieved from http://poseidon01.ssrn.com/delivery.php?ID=43300008803109703110610107708802212402807204200808401109212408211308502310809808400509800303203501811603308311110812701808408410608001203903308706810211207000409908903203009008409809908406608910809306507606602302

Saxena, S., & Villar, A. (2010). Hedging instruments in emerging market economies. Bank for International Settlements (BIS), 71–87. Retrieved from http://www.bis.org/publ/bppdf/bispap44d.pdf

Schuman, M. (2015, September 03). Emerging Markets Are Still the Future. Retrieved from Bloomberg Businessweek: http://www.bloomberg.com/news/articles/2015-09-03/emerging-markets-are-still-the-future

Snider, J. (2015, 09 26). For One Day In Brazil, Market Buys What Already Failed. Retrieved from Seekingalpha: http://seekingalpha.com/article/3535246-for-one-day-in-brazil-market-buys-what-already-failed

Waite, S. (2015, 10 05). Fortress Says Emerging Markets Bear Slump to Rival 1997. Retrieved from Bloomberg Business: http://www.bloomberg.com/news/articles/2015-10-05/fortress-says-bear-market-for-emerging-economies-to-rival-1997

Wong, E., Gough, N., & Stenvenson, A. (2015, September 09). The New York Times. Retrieved from http://www.nytimes.com/2015/09/10/world/asia/in-china-a-forceful-crackdown-in-response-to-stock-market-crisis.html

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