Global Emerging Markets In the Spotlight

Transcription

1 Strategy and Investment Global Emerging Markets In the Spotlight Today s situation in the emerging markets hardly seems comparable with the situation in the mid-1990s. Understand. Act.

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3 Strategy and Investment Content 4 Understand. 8 The Asia crisis of 1997 memories resurface 9 Focus is on current accounts 11 Countries with twin deficits 11 Foreign-currency reserves serve as a buffer 12 Emerging markets resistance to crisis: today vs Emerging markets indebtedness 17 High level of private-sector debt 18 Capital flows of international investors 19 Structural reforms are becoming more important 20 Long-term currency appreciation expected 21 Act. Imprint Allianz Global Investors Europe GmbH Bockenheimer Landstr Frankfurt am Main Global Capital Markets & Thematic Research Hans-Jörg Naumer (hjn) Stefan Scheurer (st) Data origin if not otherwise noted: Thomson Reuters Datastream 3

4 Strategy and Investment Global Emerging Markets In the Spotlight The announcement by the Chairman of the US Federal Reserve (the Fed ) that the US central bank would gradually taper its bond-buying programme caused considerable upheaval on the international debt and equity markets during the summer of Asia s emerging economies in particular saw pressure on local currencies in addition to the local equity and debt markets. In many ways this seemed reminiscent of the origins of the Asian crisis in the mid-1990s. But can the current situation in the emerging markets be compared with a crisis that took place some 15 years ago? 4

5 Understand. The summer of 2013 was a volatile one on capital markets in the emerging economies. When Fed Chairman Ben Bernanke announced in mid-may 2013 that the Fed intended to cut back its bond-purchase programme and to end it completely by mid ( Fed tapering ), the international bond and equity markets reacted with considerable upheaval. The announcement that the Fed was tapering its bond-purchase programme seemed to reverse the flow of cheap money from the world s central banks, which had been flowing primarily into the emerging markets as a result of low-interest-rate policies and the search for higher returns. The earlier capital inflow to the emerging economies turned into a capital outflow. In some cases, this sudden stop had severe repercussions on capital markets in the emerging economies. Local currencies dropped considerably (see chart 1), yields on local government bonds rose sharply (see chart 2), local equity markets also came under severe pressure (see chart 3) and all of this stirred up memories of the Asian crisis in the 1990s. A closer look at those Asian countries can shed light on whether drawing parallels with the mid-1990s is justified. Understand. Act. The current situation in the emerging markets is not comparable to the situation during the Asian crisis in the mid-1990s. Current-account deficits have largely been converted into current-account surpluses and, driven by booming exports, global emerging markets have been transformed from borrowers of capital to lenders of capital. In addition, gross national debt has been reduced and abandoning fixed exchange rates has made emerging economies more resistant to crisis. However, in some cases, short-term external borrowing and the indebtedness of the private sector have risen substantially over recent years. Slower economic growth and emerging political risks have led to capital outflows and currency devaluations, with countries such as Brazil, India, Indonesia, South Africa and Turkey receiving more attention from international investors. Long-term, however, there will be no way to avoid structural reforms if emerging markets are to remain internationally competitive and become less dependent on short-term capital. For investors, the higher bond yields in emerging markets compared to industrialized countries could serve not only as a buffer against a renewed flare-up of scepticism, but also as a component of a broadly diversified portfolio in an environment of long-term low interest rates. 5

6 Strategy and Investment Chart 1: In some cases, sharp devaluation of emerging-market currencies (vs. US-Dollar) (22 nd May th February 2014) 10 % 5 % 0 % 5 % 10 % 15 % 20 % 25 % 30 % 35 % 40 % ARS IDR TRY BRL ZAR CLP RUB INR COP THB MYR PHP MXN PEN TWDHUF SGD CNY CZK RONKRW HRK BGN PLN Past returns is not a guarantee of future results. Source: Datastream; Allianz Global Investors Capital Markets & Thematic Research, as of Feb Chart 2: sharp increase in local bond yields Taiwan Singapore Korea Philippines Thailand Malaysia China South Africa Indonesia India The Fragile Five Turkey Brazil 0.0 % 2.0 % 4.0 % 6.0 % 8.0 % 10.0 % 12.0 % 14.0 % Apr. 30 th 2013 Aug. 30 th 2013 Dec. 30 th 2013 Feb. 28 th 2014 Past returns is not a guarantee of future results. Source: Datastream; Allianz Global Investors Capital Markets & Thematic Research, as of Feb

7 Sudden stop What does it mean? The sudden-stop phenomenon occurred in various emerging markets in the 1980s and 1990s. A country that has a long-term deficit in its current account must, by definition, have a surplus in its capital account. This means that the country must continuously import capital from foreign investors. However, when economic problems arise, this inflow of capital may stop suddenly, and even turn into a capital outflow. If that happens, the local currency may come under pressure. If the country in question still has a current-account deficit, the central bank s foreign-currency reserves will be used to support the currency and / or the economy. These conditions were observed, notably, during the Asian crisis. Chart 3: and local equity markets came under pressure. Performance local Equity Markets (Total Return Indices, in %, in local Currency) 25 % 20 % 15 % 10 % 5 % 0 % 5 % 10 % 15 % 20 % 25 % South Africa Malaysia Taiwan India Philippines Singapore China Korea Brazil Indonesia Thailand Turkey Jan May 2013 May Aug Performance local Equity Markets (Total Return Indices, in %, in US-Dollar) 30 % 20 % 10 % 0 % 10 % 20 % 30 % 40 % Taiwan Malaysia Korea China Singapore Philippines India South Africa Thailand Brazil Indonesia Turkey Jan May 2013 May Aug Past returns is not a guarantee of future results. If the currency in which the past performance is displayed differs from the currency of the country in which the investor resides, then the investor should be aware that due to the exchange rate fluctuations the performance shown may be higher or lower if converted into the investor s local currency. Source: Datastream, MSCI Total Return Indices; Allianz Global Investors Capital Markets & Thematic Research, as of Feb

8 Strategy and Investment The Asia crisis of 1997 memories resurface Granted, the events of summer 2013 in the emerging markets were a strong reminder of the mid-1990s. More precisely, it was in 1997 when Asia, after years of high growth, was suddenly beset by a currency crisis of unprecedented dimensions. The impetus came from Thailand, when the central bank decided to allow the Thai Baht, which had been pegged to the US dollar, to float freely. As a result, the currency plunged by almost 20 %, triggering a panic-stricken capital flight. The crisis went on to affect the neighbouring countries of Indonesia, Malaysia, the Philippines, Singapore and South Korea. Then, as now, market participants were focused on emerging markets which, among other things, had a high level of inflation and / or a high current-account deficit (see chart 4). The countries that stand out in this context of high inflation and, in some cases, a sharply negative current account balance, are Brazil, India, Indonesia, Turkey and South Africa, also known as the fragile five. These are the countries that are highly dependent on foreign capital. In the past, thanks to extremely loose monetary policy, primarily in the USA, this was not a problem. Plenty of capital flowed into the world s emerging economies. Cheap money promoted lending, drove economic growth and raised standards of living. But too much liquidity from debt-driven growth can also be harmful if capital looking for investment opportunities is misallocated and the flow of foreign capital gradually dries up due to tapering. Therefore, even though economic growth in emerging markets is significantly higher than that of industrialized countries and their share of global gross domestic product (GDP) doubled to just under 40 % between 1997 and 2013 (see chart 5), it is still necessary to differentiate among the worldwide emerging markets. Chart 4: The Fragile Five : Current Account Balance vs. CPI 10 India 8 Turkey Indonesia CPI Jan (%, y/y) South Africa Chile Russia Brazil Mexico Philippines Malaysia Colombia Thailand China Korea Poland Czech Republic Hungary Taiwan Current Account Balance 2013 (% of GDP) Past returns is not a guarantee of future results. Source: Datastream, IMF; Allianz Global Investors Capital Markets & Thematic Research, as of Feb

9 Chart 5: Emerging markets contribution to real global economic growth 10 % 8 % 6 % 4 % 2 % 0 2 % 4 % 6 % Emerging Markets (Share of World GDP, %, rhs) GDP Growth (real) Advanced Economies IMF Forecast e 2014e 2015e 2016e 2017e 2018e Advanced Economies (Share of World GDP, %, rhs) World GDP Growth (real) GDP Growth (real) Emerging Markets Past returns is not a guarantee of future results. Source: IMF; Allianz Global Investors Capital Markets & Thematic Research, as of Feb % 90 % 80 % 70 % 60 % 50 % 40 % 30 % 20 % 10 % 0% Focus is on current accounts A glance back. In the mid-1990s, current account deficits, accompanied by inadequate foreign-currency reserves, meant that the emerging markets, with their fixed exchange rates, were vulnerable to crises. Even at that time it became clear that the emerging markets current accounts were crucially important to both the local and global economies. High deficits were amassed and financed by capital inflows from industrialized nations. Indeed, at that time, the investment boom exceeded the available pool of savings. In other words, they were living beyond their means. Today, those current-account deficits have been converted into surpluses in most cases, even though the surpluses have declined somewhat in recent years. This means that these emerging markets earn more than they spend and consequently are less dependent on foreign capital inflows. For example, thanks to a strong export sector, Malaysia has achieved a current-account surplus, even though the surplus has declined steadily in recent years. Other countries such as Thailand and the Philippines managed to balance their current accounts by the end of the 20th century. As far as current-account balances are concerned, Indonesia and India are the only Asian emerging markets that have failed to keep pace. According to the International Monetary Fund (IMF), they continue to report current-account deficits (as a % of GDP) that are even larger than in the mid-1990s. The current-account situation is similar in South Africa, Brazil and Turkey, which have reported increasingly higher deficits in recent years and, according to the IMF, will continue to remain in deficit for years to come (see chart 6). It is hardly surprising, then, that the recent focus of international investors in global emerging markets has been, above all, on the countries mentioned above Brazil, India, Indonesia, South Africa and Turkey, known as the fragile five (see chart 7). An enormous amount of capital has been withdrawn and their currencies have fallen against the 9

10 Strategy and Investment US dollar, in some cases significantly. The problem is that currency devaluation makes imports cost more. This is felt most acutely in countries that are highly dependent on raw materials, such as India, with its high level of oil imports. The result: the current-account deficit worsens and may become a negative spiral if no countermeasures are taken (e. g. monetary policy measures such as interestrate hikes). Of course, not all current-account deficits look the same. For example, if deficits are caused by infrastructure projects that are likely to promote growth, foreign investors seem to be more inclined to help finance such growth-enhancing measures. However, if the current-account deficit reflects excessive consumption, investors will be more reluctant to provide future financing for that country. Chart 6: Current Account Balances: differences within emerging markets % of GDP (aggregated) IMF Forecast China Malaysia Philippines Thailand Korea India Indonesia Taiwan Singapore South Africa Turkey Brazil Past returns is not a guarantee of future results. Source: IMF; Allianz Global Investors Capital Markets & Thematic Research, as of Feb Chart 7: The Fragile Five : Current Account Balance vs. Performance local currencies Performance local Currencies ( , %) India South Africa Turkey Chile Romania Peru Poland Czech Republic Brazil Indonesia Mexico Columbia Croatia Bulgaria Thailand Korea China Hungary Philippines Russia Malaysia Taiwan Singapore Current Account Balance 2013 (% of GDP) Past returns is not a guarantee of future results. Source: Datastream, IMF; Allianz Global Investors Capital Markets & Thematic Research, as of Feb

11 Countries with twin deficits Investors will be even more hesitant to invest in a country which has not only a currentaccount deficit, but a budget deficit as well a twin deficit. According to the IMF, in 2013, emerging markets with twin deficits included Turkey, South Africa and also India, which heavily subsidizes energy and food consumption (see chart 8). The current accounts and budgets in these countries are not expected to improve in 2014, according to the IMF, and if the currentaccount deficits get even worse (according to the IMF, deficits are projected to increase for Mexico, Romania, Poland and Peru), there may be long-term consequences. For example, as a country s capital inflows decrease, its foreign liabilities will rise. This is not necessarily a bad thing, provided that the foreign capital (= foreign direct investment) is allocated to productivity-enhancing investments that will make local products more competitive internationally and the economy less vulnerable to external factors. The current account can thus be a component in assessing the situation in emerging markets, although other fundamental indicators should be consulted in order to ensure comparability with the mid-1990s. Foreign-currency reserves serve as a buffer In emerging markets, the growth process has been, and will continue to be, driven largely by booming exports. The trend has converted this group of countries from borrowers to lenders. Whereas the emerging countries only held around 30 % of global currency reserves in the mid-1990s, they now hold nearly 70 %. Asia s emerging markets (excluding Hong Kong, Japan, Singapore, South Korea and Taiwan) account for about 40 % of currency reserves held by emerging markets, with the bulk of this (approximately 30 %) represented by China. If other Asian countries are included (Hong Kong, Japan, Singapore, South Korea and Taiwan), then the total comes to over 60 % of global currency reserves. Latin American countries, including Mexico, Chart 8: Countries with and without a twin deficit % of GDP Singapore Taiwan Malaysia Russia Korea China Philippines Hungary Bulgaria Thailand Croatia Argentinia Mexico Czech Republic Romania Poland Colombia Indonesia Brazil Current Account Balance (1997) Current Account Balance (2013) Budget Balance (2013) Chile India Peru South Africa Turkey Past returns is not a guarantee of future results. Source: IMF (IMF expectations for 2013); Allianz Global Investors Capital Markets & Thematic Research, as of Feb

12 Strategy and Investment account for around 7 % of global foreigncurrency reserves, Russia for around 4 % and the countries of the Middle East and North Africa approximately 12 %. The share of currency reserves held by the developed countries has fallen correspondingly (see chart 9). Expressed numerically, in countries such as Malaysia and Thailand where the Asian crisis originated foreign-currency reserves have jumped more than six-fold since In Taiwan, for example, foreign-currency reserves total almost 90 % of GDP. Aside from China, countries with the sharpest increase in their foreign-currency reserves (compared to the previous year) include, among others, India, South Africa and the Czech Republic, whereas foreign-currency reserves in Indonesia and Ukraine fell by more than 10 %, and in some parts of Latin America by up to 30 % currency intervention here has been notable in recent months. In respect of foreign-currency reserves both in absolute terms and within the context of external indebtedness it turns out that there is a significant difference when compared to the mid-1990s. Chart 9: Asian countries: from borrowers to lenders Share of Advanced, Emerging Market, Asian Countries and Chinas on global FX reserves (%) 80 % 70 % 60 % 50 % 40 % 30 % 20 % 10 % 0 % Advanced Economies Emerging Markets Asia (ex China)* China * Asia = Asia ex Hong Kong, Singapore, Taiwan, South Korea, Japan. Past returns is not a guarantee of future results. Source: Datastream; Allianz Global Investors Capital Markets & Thematic Research, as of Feb Emerging markets resistance to crisis: today vs Although Asian countries have not been able to completely uncouple themselves from economic developments in the US and Europe, the economy in Asia does seem to have become more resistant to external influences. As described above, strong growth in domestic markets and the balance of trade surpluses generated in recent years have not only swollen currency reserves, but also made these countries better able to cope with crises. It is not just that the gross national debt of the emerging markets averages 40 % of GDP and thus is equal to only 1 / 3 of the gross national debt of the G7 countries. Abandoning fixed exchange rates has also contributed. This stands in contrast to the mid-1990s, when exchange rates were still pegged to the US dollar and Asian countries still had high levels of debt denominated in foreign currency. Although the local currency depreciated considerably, there was a noticeable increase in the value of liabilities denominated in local currency. A look at table 1 shows the vulnerability or ability of Asian emerging markets to cope with external shocks. 12

13 For example, whereas South Korea s short-term external debt in 1997 was more than three times greater than its foreigncurrency reserves, the ratio of short-term external debt to currency reserves today is just over 30 % and the country has a solid current-account surplus. Such fundamental data show similar positive trends over time for various other Asian countries, such as Taiwan, the Philippines and Thailand. However, amongst the Fragile Five, India and Indonesia stand out. Although both countries have managed to increase their foreign-currency reserves, the trends in India in particular are negative, especially in the current account (both in absolute terms and as a percentage of GDP) and in short-term external debt (% of GDP). The current-account deficit stands at almost 5 % and short-term external debt as a percentage of foreign-currency reserves has nearly doubled since Using these benchmarks, some of the Asian emerging economies mentioned appear to be in a stronger position than in the mid- 1990s, while India and Indonesia appear more vulnerable to a crisis. 13

14 Strategy and Investment Table 1: Asian countries ability to cope with crisis: today vs Korea Taiwan Indonesia 1997 Latest 1997 Latest 1997 Latest USD bn GDP FX Reserves Current Account Short-Term External Debt Ratio FX Reserves / GDP 3.8 % 30.4 % 28.0 % 87.7 % 8.1 % 10.9 % Current Account / GDP 1.5 % 3.8 % 2.4 % 10.5 % 1.8 % 2.7 % Short-Term External Debt / FX Reserves % 32.5 % 28.0 % 30.8 % % 49.2 % Past returns is not a guarantee of future results. Source: World Bank, IMF, National Central Banks; Allianz Global Investors Capital Markets & Thematic Research, as of Feb Emerging markets indebtedness The total external debt of many emerging markets (% of GDP) appears to be significantly lower today than in the mid-1990s (see chart 11). It was 36 % of GDP at the beginning of the 1990s, and then increased to 40 % of GDP. Currently, it stands at 25 % of GDP, nearly a 30-year low. Only in the emerging economies of Eastern Europe is external indebtedness of 66 % of GDP significantly higher than in the mid-1990s (35 % of GDP). By individual country, Thailand s external debt, for example, is currently equal to 36 % of GDP, compared Chart 11: Emerging markets external debt (as % of GDP) Past returns is not a guarantee of future results. Source: Datastream; Allianz Global Investors Capital Markets & Thematic Research, as of Feb % of GDP 45 % 40 % 35 % 30 % 25 % 20 % % of GDP 80 % 70 % 60 % 50 % 40 % 30 % 20 % 10 % GEM: External debt (% of GDP) Latin America: External Debt (% of GDP) EM Asia: External Debt (% of GDP) Eastern Europe: External Debt (% of GDP) 14

15 India Malaysia Philippines Thailand China Singapore 1997 Latest 1997 Latest 1997 Latest 1997 Latest 1997 Latest 1997 aktuell % 15.1 % 21.5 % 44.8 % 9.5 % 31.9 % 17.8 % 47.1 % 15.4 % 44.6 % 71.9 % 97.0 % 1.3 % 4.8 % 5.9 % 6.1 % 4.7 % 2.9 % 2.1 % 0.0 % 3.9 % 2.3 % 15.5 % 18.6 % 16.8 % 34.9 % 69.3 % 36.5 % 72.4 % 11.9 % % 25.2 % 21.5 % 14.8 % % with over 70 % in The situation is similar in Indonesia, where external indebtedness has more than halved over the same period, dropping from over 60 % to less than 30 % of GDP. Of course, short-term debt must also be considered, comparing debt to be repaid within one year. And this short-term external debt has increased substantially in recent years in countries such as China, India, Malaysia and Turkey (see chart 12). As a result, these countries will be more vulnerable to outside factors if foreign capital is once again suddenly withdrawn. Because of its global economic importance, China could play a special role here. Thus, the decisive factor will be how those countries can reduce their short-term external debt so that they do not get into a situation similar to that of the banks in the mid-1990s, who provided short-term loans in foreign currencies (US dollar and Japanese yen), but lent that money long-term to domestic borrowers, who then bought property and securities on credit. 15

16 Strategy and Investment Chart 12: Sharp increase in short-term external debt * % of total gross external debt 80 % 70 % 60 % 50 % 40 % 30 % 20 % 10 % 0 % China Malaysia Thailand 1997 Latest Date Turkey Korea India South Africa Indonesia Vietnam Russia Brazil * Short-term debt = Short-term gross external debt banks + Short-term gross external debt general government + Short-term gross external debt monetary authority + Short-term gross external debt other sectors) / Total gross external debt Past returns is not a guarantee of future results. Source: World Bank, Datastream; Allianz Global Investors Capital Markets & Thematic Research, as of Feb

17 High level of private-sector debt In addition to (short-term) external debt, one should also look at the debt of the private sector (households and companies outside of the financial sector), as this has increased sharply over a relatively short period of time due to high levels of capital inflows in particular to China and Hong Kong during the real estate crisis in the developed markets. Admittedly, private-sector debt (as a % of GDP) in the industrialized countries is in some cases considerably higher than in the emerging markets, but it is the rapid growth in debt in recent years, particularly in the business sector, that has caused international investors to sit up and take notice. For example, private debt in Turkey jumped 24 percentage points (pp) from the end of 2007 to the second quarter of 2013, to 65 % of GDP. A similar trend was also seen in Brazil and Malaysia (where it increased 28pp, to 74 % and 137 % of GDP, respectively), Thailand (where it increased 26pp to 123 % of GDP), Singapore (up 29pp to 136 % of GDP), as well as in China and Hong Kong. In China, private debt rose 63pp to 180 % of GDP and in Hong Kong it increased 67pp to 260 % of GDP. However, there are also examples, such as India and Indonesia, where the indebtedness of companies and households only increased by around 8pp to 62 % and 37 % of GDP respectively (see chart 13). Even though emerging markets have managed to reduce their debt over the years, in some countries, the growth of short-term external debt and the relatively high debt of the private sector need to be examined more closely. Chart 13: Total indebtedness (excluding financial sector) high private-sector debt % of GDP 500 % 450 % 400 % 350 % 300 % 250 % 200 % 150 % 100 % 50 % 0 % US Switzerland UK Canada Australia Japan Germany France Netherlands Finland Italy Portugal Ireland Greece Belgium Spain Sweden Norway Past returns is not a guarantee of future results, Source: BIS, IMF, World Bank; Allianz Global Investors Capital Markets & Thematic Research, as of Q Brazil Argentinia Mexico Russia Poland Hungary Czech Republic Turkey India South Africa Saudi Arabia China Hong Kong Singapore Thailand Korea Indonesia Malaysia Chile Taiwan Government Non-financial corporates Households only aggregate debt numbers available (Non-financial corporates + Households) 17

18 Strategy and Investment 1 Source: World Bank: Global Economic Prospects: Coping with policy normalization in high-income countries, January Source: Institute of International Finance (2014): Capital Flows to Emerging Market Economies, January Source: Barry Eichengreen, Poonam Gupta (2013): Tapering Talk: The Impact of Expectations of Reduced Federal Reserve Security Purchases on Emerging Markets, December 2013 Capital flows of international investors The vulnerability of many emerging markets was obvious not just during the summer of 2013, when investors withdrew massive amounts of cash, from Brazil via Turkey to Thailand. The withdrawal of capital continued through the end of 2013 due to a sickly economy and / or the various economic differentials between the weakening emerging markets and industrialized countries that were experiencing a slight recovery (see chart 14). Emerging political risks further contributed to the outflow of capital from the equity and bond markets in emerging countries. According to financial data provider EPFR Global, investors withdrew approximately USD 60 billion from the equity and bond markets in emerging markets during the second half of 2013 (see chart 15). Some central banks, including the Turkish Central Bank, attempted to counter this with foreign-currency interventions and increases in interest rates, but the trend towards more capital outflow may persist, as slackening growth and political risks could continue in 2014, especially as parliamentary or presidential elections are scheduled in a number of countries including Brazil, India, Indonesia, South Africa and Turkey. The risk on the minds of many investors that tapering will cause bond yields in the industrialized countries to rise sharply and result in further capital outflows from the emerging markets that could once again add to the vulnerability of those countries is considered by the World Bank to be manageable. 1 The Institute of International Finance (IIF) even assumes that capital will gradually flow back into the emerging markets over each of the next two years. 2 It is also interesting to note that, according to a study by Barry Eichengreen and Poonam Gupta, it was not the substantial currentaccount deficits, high level of debt or low economic growth in some emerging market countries that led international investors to withdraw capital. On the contrary, according to their study, investors did not differentiate among the emerging markets considered. 3 The trend in recent months, therefore, shows that active management is becoming increasingly important, including for this asset class. Chart 14: Shrinking growth differential 10 % 8 % IMF Forecast 6 % 4 % 2 % 0 % 2 % 4 % e 2016e 2018e GDP Growth Difference Real GDP Growth-Advanced economies Real GDP Growth-Emerging Markets Past returns is not a guarantee of future results. Source: IMF; Allianz Global Investors Capital Markets & Thematic Research, as of Feb

19 Chart 15: Emerging markets face sharp capital outflows bn USD Jan. 07 Apr. 07 Jul. 07 Cumulative Inflows EM Equity EM Bonds Oct. 07 Jan. 08 Apr. 08 Jul. 08 Oct. 08 Jan. 09 Apr. 09 Jul. 09 Oct. 09 Jan. 10 Apr. 10 Jul. 10 Oct. 10 Jan. 11 Apr. 11 Jul. 11 Oct. 11 Jan. 12 Apr. 12 Jul. 12 Oct. 12 Jan. 13 Apr. 13 Past returns is not a guarantee of future results. Source: EPFR Global (Monthly Values; Equities Emerging Markets: Investment Funds + Exchange Traded Funds); Allianz Global Investors Capital Markets & Thematic Research, as of Feb Structural reforms are becoming more important Over the long term, the future performance of the emerging markets may depend, among other things, on how their economies adjust to increasing interest rates and an end to cheap money, or how attractive the emerging markets continue to be to foreign investors. Higher interest rates which we have seen recently in Brazil, India, Turkey and South Africa appear to be one way to improve the current account by making the local currency more attractive for investors, thereby making it easier to finance the deficit. But higher interest rates dampen economic growth. Long-term, however, if countries want to Jul. 13 Oct. 13 Jan. 14 remain internationally competitive and to be less dependent on short-term capital, there will be no avoiding structural reforms. Mexico, for example, has passed laws reforming its labour market and its energy sector. In future, both domestic and foreign investment will be allowed for the exploration and development of Mexican oil and gas fields. Besides India which among other things has opened various sectors of its economy to foreign direct investments China, especially, announced extensive reforms in autumn 2013 aimed at making the country less dependent on exports over the next few years, and instead supporting the transition to consumer-oriented growth. 19

20 Strategy and Investment Long-term currency appreciation expected 4 see also The Case for Emerging Market Currencies in the Long Run at Not only did the decision of the US Federal Reserve to gradually reduce its bond-buying programme place the equity and bond markets in many emerging markets under pressure, it also caused their currencies to depreciate significantly against the US dollar. Nevertheless, tapering should also be seen as a sign of economic recovery. Economic recovery in the USA (and in Europe) can be considered positive for global emerging markets in Asia, Latin America and Eastern Europe. We therefore expect the currencies of many global emerging markets to show a real appreciation against the US dollar over the medium to long term (based on the Balassa- Samuelson theory) 4 (see chart 16). Chart 16: Expected real appreciation in exchange rate against the US dollar up to % 30 % 20 % 10 % 0 % 10 % 20 % Vietnam Peru Columbia Brazil Mexico Saudi Arabia Chile Israel Philippines Ukraine Thailand Past returns is not a guarantee of future results. Source: Allianz Global Investors Economics & Strategy Singapore Hungary Czech Republic Argentinia Malaysia Russia Turkey Poland Hong Kong Taiwan Korea Romania Indonesia China South Africa India 20

21 Act. Regardless of this, today s situation in the emerging markets hardly seems comparable with the situation in the mid-1990s based on the points discussed above. Many emerging markets have largely converted their current-account deficits into current-account surpluses; they have accumulated sufficient foreign-exchange reserves thanks to booming exports and have largely reduced their (short-term) external debt (as a percentage of foreign-exchange reserves) and therefore appear less vulnerable to external shocks. However, developments during the summer of 2013 made it clear that even emerging markets are not immune from the need to push ahead with structural reforms in order to generate sustainable growth all the more so, since these countries share of the global economy has increased substantially over the past two decades. At a time when international investors are questioning the export-based growth model of the emerging markets, and political uncertainty is putting a brake on economic performance in some emerging markets during this election year, structural reforms look to be an important way of winning back investors money and demonstrating that 2013 cannot be compared with the situation in the mid-1990s. For investors, the higher bond yields in emerging markets compared to industrialized countries may serve not only as a buffer against a renewed flare-up of scepticism, but also as a component of a broadly diversified portfolio for generating a positive real return after inflation in an environment of long-term low interest rates. Of course, in considering opportunities and risks, investors should ask themselves whether, from a risk-reward standpoint, the risk premium on the bonds of specific emerging markets is high enough to compensate for the political risks, the sometimes mixed fundamental data and potentially higher volatility. Stefan Scheurer 21

22 Strategy and Investment Do you know the other publications of Allianz GI Global Capital Markets & Thematic Research Risk. Management. Reward. Smart Risk with multi asset solutions Smart Risk investing in times of financial repression Strategic Asset Allocation Managing Risk in a time of Deleveraging Active Management The New Zoology of Investment Risk Management Constant Proportion Portfolio Insurance (CPPI) Dynamic Risk Parity a smart way to manage risks Portfolio Health Check : Preparing for Financial Repression Financial Repression Shrinking mountains of debt International monetary policy in the era of financial repression: a paradigm shift Silent Deleveraging or debt haircut? that is the question Financial Repression A silent way to reduce debt Financial Repression It is happening already Bonds Duration Risk: Anatomy of modern bond bear markets Emerging Market currencies are likely to appreciate in the coming years High Yield corporate bonds US High-Yield Bond Market Large, Liquid, Attractive Credit Spread Compensation for Default Corporate Bonds Strategy and Investment Equities the new safe option for portfolios? Is small beautiful? Dividend Stocks an attractive addition to a portfolio Changing World Renewable Energies Investing against the climate change The green Kondratieff Crises: The Creative Power of Destruction Infrastructure The Backbone of the Global Economy Demography Pension Discount rates low on the reporting dates Financial Repression and Regulation: A Paradigm Shift for Insurance Companies & Institutions for Occupational Retirement Provision IFRS Accounting of Pension Obligations Demographic Turning Point (Part 1) Pension Systems in a Demographic Transition (Part 2) Demography as an Investment Opportunity (Part 3) Behavioral Finance Reining in Lack of Investor Discipline: The Ulysses Strategy Overcoming Investor Paralysis: Invest more tomorrow Outsmart yourself! Investors are only human too Two minds at work All our publications, analysis and studies can be found on the following webpage: / AllianzGI_VIEW 22

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