Dizzy in Boomtoom

From the Economist last week:


Dizzy in Boomtown

Nov 15th 2007 | HONG KONG
From The Economist print edition
The boom in emerging economies and their stockmarkets is not over yet. But some are likely to run out of breath sooner than others.

THE world is experiencing one of the biggest revolutions in history, as economic power shifts from the developed world to China and other emerging giants. Thanks to market reforms, emerging economies are growing much faster than developed ones. There is a widening gap between their growth rate and that of the sluggish developed world (see chart 1). According to the IMF, this year they are growing almost four times as fast.

Emerging economies account for 30% of world GDP at market exchange rates (and over half using purchasing-power parity to take account of price differences). At market exchange rates they already account for half of global GDP growth. And by a wide range of measures, their weight is looming larger. Their exports are 45% of the world total; they consume over half of the world's energy and have accounted for four-fifths of the growth in oil demand in the past five years (explaining why oil prices are so high); and they are sitting on 75% of global foreign-exchange reserves.

The increasing strength of emerging economies has been reflected in their stockmarkets, which have climbed steeply in recent years. Share prices in many emerging economies are showing signs of altitude sickness, with recent sharp falls in China and other markets. Even so, since 2003 Morgan Stanley Capital International's emerging-market index has jumped more than fourfold in dollar terms, compared with an increase of only 70% in America's S&P 500. Top of the mountain has been Brazil, with an incredible gain of 900% (see chart 2). Over the same period, emerging economies' output has grown by 35%; the developed world's by only 10%. More than ever before, emerging economies are being relied upon to help lift the world economy. But can they keep up the effort?

Sounder footings

They may be able to. On many measures emerging economies look sounder than some developed ones. As a group they are no longer financially dependent on foreigners: together they run a current-account surplus, and thanks to large reserves and reduced debts, are now net foreign creditors. They have smaller budget deficits, on average, than rich countries, and inflation rates remain historically low. Unlike so often in the past, most currencies do not appear to be notably overvalued and hence prone to collapse; if anything, many are undervalued.

What is most striking is that this year, for the fourth year running, all of the 32 emerging economies tracked by The Economist show positive growth. This is a remarkable turnabout: in every previous year since the 1970s at least one suffered a recession, if not a severe financial crisis.

But it is dangerous to treat emerging economies as homogenous. This brings back alarming memories of the early 1990s, when investors poured money into any fund with an “emerging market” tag. On April 1st 1994, when buying fever was at its peak, a Hong Kong stockbroker advised clients to buy shares in Bhutan Dry Docks. He immediately received several large orders even though Bhutan is a landlocked Himalayan kingdom which then did not even have a stockmarket.

Investors need to discriminate carefully between countries. Although emerging economies have never before looked so healthy, aggregate numbers conceal some horrors. Table 3 shows The Economist's ranking of 15 of the biggest economies according to potential economic risk. It is based on the size of current-account balances, budget deficits, credit growth and inflation. A country's overall score is arrived at from the sum of the rankings of each indicator. It is obviously only a crude gauge, but it reflects the economic factors that have caused trouble in the past. A similar ranking would have flashed red for Thailand in early 1997 just before the Asian financial crisis.

The riskiest economies, all with current-account deficits and relatively high consumer-price inflation, are India, Turkey and Hungary. Those with current-account deficits are vulnerable to a sudden outflow of capital if global investors become more risk averse. Economies where inflation and credit growth are already high and budget deficits large, such as India, have less room to ease monetary or fiscal policy if the economy weakens.

Being irrational

The nature of capital inflows also matters. Foreign direct investment is much safer than speculative capital. But according to Chetan Ahya, an economist at Morgan Stanley, 85% of India's capital inflows this year have been in the form of debt or portfolio investment, much of which has gone into the stockmarket. India shows dangerous signs of irrational exuberance. It was swept by euphoria last month as the Sensex, India's benchmarket index, hit 20,000 for the first time. India's Economic Times declared, “The first 10,000 took over 20 years. The next came in just 20 months...Superpower 2020?” Instead, India's poor risk-rating should ring alarm bells.

China's economy looks less risky thanks to a small official budget deficit (many reckon that it really has a surplus) and its vast current-account surplus and reserves. The other two members of the so-called BRIC group, Brazil and Russia, also have a better risk-rating than India. Russia's credit boom is frightening, with lending up by 55% in the past year, but the economy is sheltered by large external and budget surpluses, thanks to high oil prices. After running a current-account deficit for most of the previous three decades, Brazil has had a surplus for five years—also thanks to robust commodity prices.

Emerging Europe, however, is flashing red, with widening current-account deficits, rising inflation, soaring bank lending and property bubbles. Indeed, Hungary and Turkey appear prudent compared with the Baltic states. Latvia has a current-account deficit of 24% of GDP, inflation of 13% and property prices rising at an annual 60%. The economy is seriously overheating, but its currency is pegged to the euro, which means it cannot raise interest rates. Estonia, Lithuania, Bulgaria and Romania also have current-account deficits of more than 12% of GDP. If these smaller economies were included in the table they would all rank at the bottom, below India.

A large chunk of bank lending in the Baltics and other parts of emerging Europe has been denominated in, or indexed to, foreign currency. The combination of large external financing needs and private-sector currency mismatches looks suspiciously like Thailand in 1997. These economies are highly vulnerable to a change in investor sentiment: if a rapid outflow of capital caused currencies to collapse, debts would soar in local-currency terms.

At the other extreme, Thailand, Malaysia, Taiwan and South Korea have not only the lowest risk ratings, but also share prices that look less overvalued than elsewhere. In Thailand, Malaysia and Taiwan price/earnings (p/e) ratios are still below their 20-year average.

Emerging stockmarkets now have a higher average p/e ratio than developed markets for the first time since the early 1990s. Stocks used to trade at a discount because these markets were seen as riskier. Now their economies are less wobbly and profits grow faster than in the rich world. This might justify a higher valuation. But the size of some p/e ratios causes concern that a bubble is in the making.

There was a stumble in emerging markets this summer when America's subprime crisis began to unfold. But after the Federal Reserve cut its discount rate in August investors eagerly returned, pushing prices up by an average of 40% in dollar terms by the end of October. Markets that looked cheap in August started to look dear, so it is hardly surprising that some investors have recently needed a breather.

In any case, the average p/e ratio in emerging markets may be distorted upwards because of a different industrial mix. Some types of businesses have consistently higher ratios, and emerging-countries tend to have more of them. When comparing like with like, the average p/e is still lower in emerging economies than in the developed world, according to UBS.


International comparisons can also be blurred by different accounting conventions. It is better to compare a country's p/e ratio with its own track record. Emerging markets' average p/e of 14.7 (based on forecast 2008 profits) is now above its 20-year average of 14, but it is nevertheless still well below previous peaks (see chart 4).

China A shares have been the frothiest this year, up by 104%. Thanks to frenzied buying at its stockmarket debut, PetroChina is now by some measures the world's most valuable company—three of the world's five largest companies are Chinese. A forward p/e ratio for A shares of 40 (again, based on forecast profits) certainly looks bubbly, but it too is much lower than in previous bubbles. The p/e reached 80 in Japan in the late 1980s, while on America's NASDAQ it hit 90 in 2000.

The p/e for Chinese shares that foreigners can buy is a more modest 22, well below the 40 reached in 2000. In contrast, Indian shares, also with a p/e of 22, have never been so overvalued. And while p/e ratios of 11-12 in Russia and Brazil seem like a screaming buy, relative to their historical averages of 7-8 they look generous.
Rolling along

Emerging stockmarkets experienced a similar boom in the early 1990s, until ended by a series of painful crises: Mexico at the end of 1994, East Asia in 1997, Russia in 1998, Brazil in 1999, Turkey in 2000, Argentina in 2001 and Venezuela in 2002. By 2002 the Morgan Stanley emerging-market index had lost almost 60% of its 1994 dollar value. So why should the current boom be any more sustainable?

A common feature of bubbles, such as America's dotcom mania and more recently its housing boom, is that most people refuse to believe they are bubbles until they burst. In sharp contrast, plenty of people have denounced China's stockmarket as a bubble, most notably Alan Greenspan, the former chairman of the Fed. The recent dive in prices makes such warnings seem prescient.

Yet a report by Goldman Sachs argues that many of the common symptoms seen when bubbles are about to burst are missing in today's emerging markets. Not only are p/e ratios much lower than in previous bubbles, but economic and financial imbalances created by rising asset prices, such as widening external deficits, are also absent from many economies. Likewise, before bubbles burst, notably America in the late 1990s and Asia in 1997, profits started to shrink. They are still growing strongly in China and the rest of Asia.

There is also ample global liquidity to fuel further gains. Just as previous interest-rate cuts by the Fed helped to pump up both the dotcom bubble and America's housing bubble, further easing over the next year could inflate emerging markets even more. These economies' domestic monetary conditions are also loose. Over the past year their broad money supply has increased by an average of almost 20%, accounting for a staggering three-fifths of the total expansion in the world's money. The surplus of money growth over and above the growth in nominal GDP (a crude measure of the money available to be invested in financial assets) has been growing at its fastest pace for years.

Several analysts therefore predict that after taking a short breather, emerging-market mania will resume. Bubbles will get bigger before they burst. Chris Wood, a strategist at CLSA, predicts that emerging Asia's forward p/e ratio will peak at twice America's. The premium now is only 5%.

Foreign money seems likely to continue to pour into emerging-country stockmarkets, if only because they lag so far behind the rest of the world. While emerging countries account for 30% of world GDP, they account for only 11% of world stock-market capitalisation.

Over the coming years, faster growth in profits and hence share prices, along with new share issues by companies, will almost certainly boost the value of these markets. According to a recent report by Ernst & Young, China, India, Russia and Brazil accounted for nearly half of all money raised worldwide in initial public offerings in the third quarter of this year.

One risk is that such prospects will attract too much interest from abroad. The surge in emerging-market shares has been a boon for international investors, but large inflows of foreign capital may be less welcome to governments and central banks. According to the IMF, net inflows of private capital to emerging economies have surged to almost 4% of their GDP on average this year, surpassing the peak of the previous wave in the first half of the 1990s. Net inflows to Brazil and Argentina have been running at 5-6% of GDP; and emerging Europe even more.

Vast capital inflows can harm economies in several ways. Not only can they inflate asset bubbles and spur excessive borrowing, but they can also cause a steep rise in the exchange rate, damaging the competitiveness of export sectors. If a country already has a current-account deficit this will make it even more vulnerable to a quick reversal of capital. On the other hand, if central banks intervene to hold down their currencies, the build-up of reserves can lead to excessively loose monetary conditions and rising inflation. This is exactly what is happening in much of emerging Europe.

Many other emerging economies have allowed their exchange rates to rise against the dollar. The Brazilian real has jumped by 23% this year, and by a total of 100% since 2003. In response to rising inflation, the Reserve Bank of India has allowed the rupee to rise by 12% since April. It has been greeted with howls of protest from business, yet the rupee has risen by no more than the Chinese yuan since mid-2005 and by much less than many other Asian currencies, such as the Thai baht.

Could a sudden crash in emerging stockmarkets derail the boom? Most stockmarkets are much smaller in relation to GDP than in developed economies, so the wealth effects of a crash would be modest. The East Asian economic slump in the 1990s was not caused by stockmarkets crashing, but by over-borrowing and the severe currency mismatches which caused the local currency value of debt to explode when currencies fell. This is a serious risk in the Baltics, but elsewhere most economies do not display the same sort of financial imbalances.

A more imminent threat is the impact of an American recession. Economists argue fiercely about whether emerging economies can decouple from the United States, yet by some measures they seem to have done so already. Emerging economies' exports to America slowed markedly this year, but their GDP growth has been supported by robust domestic demand and strong exports elsewhere.

If exports to America weaken further, many governments can support demand by boosting public spending, thanks to more prudent budgeting than in the past. Anyway, America is less important as an importer than it used to be. The share of China's exports going to America (including re-exports through Hong Kong) has fallen from 34% in 1999 to 24% now. China exports more to other emerging economies, which as a group now send more to China than to America. This partly explains why as American imports have slowed this year, the emerging world has continued to boom. So long as China's economy remains robust, it will help to pull other emerging economies along.

Indeed, this year for the first time emerging economies are likely to have bought slightly over half of America's exports, helping to prop up the economy of the United States. Some years into the future, economists may instead ask: “Can America decouple from China?”