It is illuminating to compare the situation in the capital markets today to the situation a decade ago. In 1998, emerging markets all around the world were in deep trouble. Many states were forced to devalue their currencies, many emerging market banks went bankrupt, several governments defaulted on their debt.
Emerging markets looked to the West, particularly to the US Treasury and the International Monetary Fund, to bail them out. The arrival of Michel Camdessus, head of the IMF, in Moscow or Bangkok was an occasion of great pomp and significance. Would the IMF sign off a new emergency loan package? Would the West save emerging markets?
In fact, Western institutions simply pulled their capital out of emerging markets, and put it back into Western markets, which were considered much safer, and were in the middle of the dot com boom.
Apart from the collapse of the hedge fund Long Term Capital Management in 1998, the suffering of emerging market economies affected the prosperity of Western markets only at the margins.
Fast forward to 2008, and the situation is curiously reversed. Now, its Western markets that are in deep trouble, particularly the US. The dollar is dangerously weak, many Western banks are near collapse, and they are begging their shareholders and creditors for cash injections.
And who are their shareholders and creditors? Emerging market investors. In the last nine months, investors from Asia and the Middle East have put tens of billions of dollars into the Western financial system, partly to invest their surplus capital, but also to keep the banks from collapsing.
A lot of the investment has come from state-owned sovereign wealth funds (SWFs). For example, Singapores Temasek Holdings has invested around $20bn in Barclays, Standard Chartered and Merrill Lynch, while the Government of Singapore Investment Corp has put $11bn into UBS and $6.9bn into Citigroup.
The China Investment Corporation has taken a $5bn stake in Morgan Stanley and invested $3bn in Blackstone. The Abu Dhabi Investment Authority bought $7.5bn of Citigroup equity.
And so on. Its been like a Marshall Plan in reverse. How did this happen? How did the tables turn so dramatically?
Record commodities prices
Part of the story, of course, is the extraordinary boom in commodity prices over the last eight years. The oil price in 1998 was just $11 a barrel, which translated into weak revenues for many emerging market governments. Conversely, now the oil price is consistently over $100 a barrel, oil-rich countries have more cash than they know what to do with.
But they have also become a lot smarter with their oil windfalls. The obvious example is Russia. Sergei Storchak, former Russian deputy finance minister, told EuroWeek: "The 1998 crisis was a real lesson for the political elite in Russia. It decided it had to pursue a much more prudent fiscal policy."
Thats precisely what President Vladimir Putin did when he came to power in 2000. As the oil price started to rise, Putins finance minister, Alexei Kudrin, stowed away the petrodollars in a Stabilisation Fund, and used it to pay off IMF and London Club debt, taking the country to investment grade in 2003, and making it a net creditor shortly afterwards.
The Gulf countries have also become more adept in managing their oil wealth. Where in the 1980s they poured it into white elephant investment projects like Saudi Arabias attempt to become an exporter of corn, now they have put their wealth into giant funds that try to find efficient and profitable investments.
Better policies too
But the strength of emerging markets today is not just due to commodities. Emerging market policymakers have become much better at learning how to manage globalisation. "In the old model, local policymakers wouldnt undertake fiscal or economic reforms unless they were told to by the IMF," says Philip Poole, global head of emerging market research at HSBC in London. "In the new model, they take these steps anyway."
Most emerging market countries now understand, in a way they did not 10 years ago, the need to balance their books and run small budget deficits. Georgia, for example, has just passed a new financial package law which, in the words of its prime minister Lado Gurgenidze: "will mean the government is required by law to be in fiscal surplus".
Emerging market central banks have also learnt the lesson of 1998 keep the currency stable and foreign currency reserves high. Chinas central bank now has foreign reserves totalling $1.6tr, Russias has $519bn, India $314bn, Taiwan $287bn, South Korea $264bn, Brazil $195bn, and Singapore $178bn.
And such countries have learnt that, with multinationals eager to reduce their labour and production costs, they have everything to gain from the globalisation of manufacturing and services.
"Emerging market economies have benefited from the trend whereby Western corporates have offshored services and manufacturing," says Poole. "The move by emerging markets to join the World Trade Organisation over the last decade has helped these processes significantly. China joining the WTO in 2001 was a benchmark."
Emerging market countries have also benefited from another aspect of globalisation the movement of labour from emerging to developed economies. As Poole says: "Remittances [from migrant workers] are now a major source of capital for emerging market countries. In the Philippines, for example, its equal to 12% of GDP."
These favourable economic changes have naturally reduced credit risk in the emerging markets. For each of the past five years, the number of emerging market governments credit ratings upgraded by Standard & Poors has exceeded the number of downgrades. To take a market measure, the spread between US Treasuries and emerging market sovereign debt has got ever narrower, particularly as several countries in central and eastern Europe have joined the EU.
But is the party over?
However, this benign trend cannot be expected to continue without interruption forever. Emerging market economies have had it all their way over the last decade, as low interest rates in the US have encouraged Western investors to look for higher yields in emerging markets. This has made it progressively easier for emerging market governments and companies to borrow internationally.
This has now changed. There wasnt a single corporate Eurobond from an emerging market issuer in the first quarter of 2008. The few sovereign bonds that were launched, such as Latvias Eu400m offering in February, did badly. Finally, in April, the corporate market reopened with a few new issues from Russias Gazprom and Evraz and Kazakhstans Halyk Bank but there is a recognition that funding conditions have changed.
"Gazproms $1.5bn offer in April was a benchmark. It came at a premium of around 50bp to Gazproms yield curve, and it finally showed issuers the new rules of the game," says Tijen Taraf, executive director of EMEA debt capital markets at UBS in London. "Borrowers will have to pay a premium to what they were paying last year if they want to borrow. And they will have to work much harder to listen to investors and heed their concerns."
It is a buyers market now. "In some ways, the new conditions make it easier for investors," says Didier Lambert, manager of the emerging market fixed income portfolio at Fortis Investments in London. "We now have more time to do proper credit analysis on issues, to talk to borrowers, to get our points across. Its more like a private placement market."
The price of borrowing has gone up, and it is not likely to go back to 2007 levels any time soon. That will make things difficult for some emerging market borrowers.
Standard & Poors believes sovereign downgrades could outnumber upgrades this year, for the first time for six years. John Chambers, head of the sovereign ratings committee at S&P in New York, points out that Hungary, Pakistan, Serbia, Turkey, Ukraine and Sri Lanka are all on negative outlooks. "These six governments are poorly placed, at their current ratings levels, to trim their sales if the winds shift," he says.
Some of these problems are country-specific. Serbias angry reaction to Kosovan independence has derailed its convergence with the EU; Turkeys ruling AKP party is at odds with the army; Hungarys coalition government has fallen apart; and Ukraine has basically been without a government for the last three years.
But another problem is common to many emerging market countries: inflation. Many emerging market countries are growing at rates their economies cannot sustain.
It is a result partly of high commodity prices bringing a lot of capital into the money supply of resource-rich countries; partly of excessive international borrowing by emerging market companies; and partly of rising food prices around the world.
Still, inflation is a real concern for many emerging market governments, and is often at 10%-20%. Hyperinflation has only occurred in Zimbabwe so far, but in some countries, such as Ukraine, it is starting to rise worryingly quickly.
The problem for many countries is that, particularly with food prices rising steeply, inflation can lead to social discontent, even riots in the streets. So what can governments do about it?
Emerging market governments at least have one option, which is not available to the US: put up interest rates and buy the local currency. Jerome Booth, head of research at Ashmore Capital in London, says: "That will slow economic growth somewhat, but if your economy is growing at rates of 11%, like China, or 7%, like Russia, you can afford to lose a percentage point or two on growth. The US is in a much harder position. It is facing stagflation low growth and high inflation."
Many emerging market currencies are pegged to the dollar, and that is causing them problems as the dollar slides. This year, several central banks have already moved to rectify this both Hungary and Ukraines central banks have allowed their currencies to float more freely in the last three months. The Arab states of the Gulf have also discussed letting their currencies float more freely, but may retain their currency regimes in order to pursue their goal of monetary union.
Booth expects the dollar to sell off much more sharply in the coming months, as emerging markets allow their currencies to appreciate and sell off dollar assets. "Emerging market currencies could appreciate by as much as 30% against the dollar," he says.
Domestic investment boom
Hand in hand with this appreciation, emerging market investors may also keep a lot more money in their domestic markets, or put it elsewhere in the emerging markets, rather than into Western assets.
"Emerging markets have been net exporters of capital in previous years, because theres been an assumption than Western assets are less risky," Booth says. "No one believed US Treasuries could be risky. Thats changed now. Its not that emerging markets are a safe haven, its a realisation that there are risks everywhere."
This flow of emerging market-controlled capital back to emerging markets has already begun. The biggest driver of mergers and acquisitions in emerging markets is no longer Western firms buying local firms. Its local firms buying local firms.
"Its not peculiar of Russia, you see it in the Middle East, you see it in India, you see it in Ukraine," says Stephen Cohen, managing director of Troika Dialog Asset Management in London. "The local-to-local thing is one of the big emerging trends of the last five years."
Gulf investors are now big investors in the CIS, CIS countries are pouring money into eastern Europe and Africa, China is the biggest investor in Africa, South
African firms are investing more and more in sub-
As local investors become more important, so, too, emerging market exchanges are growing in importance. The Hong Kong Stock Exchange is on track to become the most active exchange in the world. The Warsaw Stock Exchange is booming. The Dubai International Financial Exchange is ambitious to become a centre for Islamic finance, and was already home to one of the biggest IPOs in the world last year, the $5bn IPO of local ports group DP World. St Petersburg is bidding to become a global centre for oil trading.
So there are new rules of the funding game, new capital flows, and new leaders of the global economy. For organisations like the International Capital Market Association, that means there is a lot of work to be done, to try and ensure common standardisation across these booming new markets, so that while financial power shifts to new regions, global standards of transparency and market reliability remain high.