Are Emerging Markets Proving Their Detractors Right?

After more than a decade as the darlings of the investment world, Emerging Markets (EM’s) have fallen out of favour rapidly as it becomes apparent that they are not following the linear path to prosperity that many had envisioned. Whereas previously the investment world focussed on the seemingly unlimited potential of billions of new consumers, recent events in such disparate countries as Turkey, Thailand, Nigeria and Ukraine highlighted the fragility of governance and institutions that is typical of emerging markets. Other EM’s such as South Africa, Brazil and India have not seen political crisis, but have still come under scrutiny due to their falling growth rates and rising inflation.

Over the last decades, EM’s have been the beneficiary of massive capital flows, partly due to their potential for economic growth, but in recent years also due to the flood of money brought on by ultra-easy monetary policy (low interest rates and quantitative easing) in developed markets. With the prospect of ultra-easy monetary policy coming to an end, EM’s will have to provide an attractive environment for capital in order to fund their investment plans. Sceptics contend that most EM’s are stuck in the “middle-income trap”. The theory is that an EM can grow from being a poor country to a middle-income country by capitalising on natural resources or cheap labour, but it then gets stuck in a “trap” when it does not have the strength of educational, legal and social institutions necessary to continue its development into a higher-income country. Capital flows are not effectively absorbed into the economy but instead they fuel a temporary consumption boom. A consumption boom without improvements in productivity eventually leads to a crisis followed by a reversal of capital flows. While each EM has its own unique circumstances, this sequence of events does seem to accurately describe many countries in the EM universe, including Turkey, Brazil, India and South Africa.

Recent events have highlighted the weakness in EM institutions, and their ability to negatively impact the growth potential of a country. In Turkey, Prime Minister Erdogan seems to be turning into the autocratic ruler that many had been warning of. The recent corruption scandal has seen him launch an offensive against the judiciary and police the media, and now even the Internet. Turkey’s mishandling of their monetary policy over the last year, also due to political pressure, has resulted in a dramatic fall in the currency. Nigeria has experienced rapid economic growth in recent years despite its high level of corruption. The firing of Reserve Bank governor Sansui after he exposed a $20bn hole in the state oil company’s finances highlights how weak Nigerian institutions are. Investors see immense potential due to the population of 170 million people, but this potential won’t be realized if the state continues to mismanage the economy.

On the ground in South Africa, we are painfully aware of the difficulty of generating a level of economic growth necessary to reduce unemployment, poverty and inequality. SA has struggled to generate more than 2% growth over the last 2 years and it clear that development has stalled. While SA’s institutions are amongst the strongest in the EM universe, the country is constrained by poor educational outcomes that limit productivity growth.  Recent years have also been characterized by deterioration in the efficiency and effectiveness of government institutions. This has created a high level of uncertainty that has limited investment in the economy.

As a citizen of an emerging market, I am not just an impartial observer in the recent reversal of fortunes. Whilst I think that the euphoria around EM over the last decade was in part due to ignorance about the developmental challenges these countries face, the current pessimism (and market valuations) seems to imply that progress has permanently stalled. EM may currently be regarded as a poor investment destination, but if governments can create the right environment then convergence can resume and EM’s can outperform developed economies for a considerable period of time.

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