Monday, 27th May, 1997
During 1993, the buying fever for emerging market shares was at its peak and each day a mutual fund specializing in investment in ever more exotic locations seemed to appear. Mexico, Latin America and even post communist Eastern Europe were in turn touted as the next 'dragon' economies of the 90's. Unfortunately, anybody who put cash into an emerging market equity fund three years ago, lured by the promise of vast rewards, is likely to be feeling a little discontented. The International Finance Corporation's (IFG) investable index, which measures the prices of emerging market shares that foreigners can buy (quoted weekly in The Economist, or periodically in Barrons) has fallen 7 percent in dollar terms from the end of 1993 to the first quarter of 1997. To add insult to financial injury Wall Street, as measured by the Standard and Poors 500 has climbed by 75 percent over the same period. To further rub it in the three major American indexes, The Dow Jones Industrial Average, the Standard and Poor's 500 and even the lagging NASDAQ composite, reached record highs on Friday May 24. If an index containing Jordan, Estonia, Trinidad and Tobago, and Botswana, along with 24 other truly emerging nations can not outperform an index of America's emerging companies is there any purpose to putting one's money into such far-flung shares? In answer to this question this essay proposes to examine the current condition of emerging markets in light of recent disappointments from the end of 1993 to the present. It will be shown that the long-term benefits of such investments remain strong and alternatives to volatile direct investment exist.
Why have so many emerging markets failed to live up to their promise over the past three years? One reason is that they were over-hyped back in the early 1990's, when the combination of low domestic interest rates and the misguided belief that small markets could only rise, caused vast capital inflows into the worlds smallest bourses. According to the Institute for International Finance, a Washington based association of the world's major financial institutions, "The flow of private capital into emerging markets jumped to $105 billion in1993 from $57 billion in 1990" (Fuerbringer, page, c6). Further, in the Economist the scale of these capital flows is related by using the example of Hungary, "Which in 1994 received $1.1 billion in foreign investment, or $111 per person:" (The Economist, vol. 338, page100). Naturally, enough these vast new inflows caused equity valuations to rise to heights even economies with 6 to 7 percent annual growth in gross domestic product could not support. A pin was finally applied to this bubble during 1994 when six successive interest rate increases by the Federal Reserve Board challenged the twin assumptions of ever increasing returns from exotic markets. Now, for the first time since the moderate economic recession of 1991, the rates on domestic bonds turned upwards and offered a degree of competition to their less familiar brethren. The short-term and inevitable correction that followed would perhaps not have caused the lagging returns still felt today if the situation in SouthEast Asia and Mexico had been different. In the case of the Asian tigers, growth rates in the 8 to 9 percent range were already a thing of the past as these countries became ever more developed, and an overdue cyclical downturn was probably already underway by early 1993. For Mexico, the rising costs of selling debt to foreigners exposed its massive balance of payments problems and unsustainable level of government borrowing, which in turn precipitated the Paso crisis of early 1995 (Chote, page 7). Taken together these events caused declines in markets whose fundamentals remained unchanged by this short-term turmoil and caused many who saw emerging markets as a one-way bet to return to more familiar fields.
Does this mean that emerging market investment is an ill-considered adventure? Not necessarily. Emerging markets were always meant to be long-term investments and "from 1985 to 1995 the Morgan Stanley Capital International's EAFE index of foreign stocks has significantly outperformed the S&P 500 - delivering a cumulative return of 403 percent versus 283" (Economist, vol. 337, page 121). However good though these numbers are, the rationale for an emerging market investment is perhaps best made in terns of the relative macroeconomics opportunities offered. The U.S., like most mature economies, has seen average growth of GDP of around 3 percent since the end of World War Two and yet the average multiple on an S&P 500 issue is 21.4 times earnings. In contrast to which the IFG's expectations are for "5.7 percent expansion in emerging markets economies during 1997... and accompanying net direct, (non-governmental) capital investments of $240 billion." This, the institute latest report argues, "represents an efficient allocation of world capital towards high-return investments, rather than the slide towards overborrowing that precipitated the debt crisis of the 1980's" (Chote, page 7). From an individual investor's perspective, the crux of the matter is that corporations are prepared to invest record sums in the smaller economies of the world because of the potential for growth is so strong. Further, the shares of local corporations, which must ultimately partake in any domestic expansion, trade at average multiples below those of their bigger but slower growing brethren. For example "the stock markets of Brazil and Poland both trade at 10 times earnings, while their expected growth rates are 6.5 and 7.3 percent respectively" (Perspectives, page 8).
If a prime reason for emerging market investments is their current relative cheapness, both historically and next to those of developed nations, can a longer-term case be made? Clearly, the events of the recent past have moved many smaller economies away from state planning and towards more free-market economies. This liberation has led to sweeping changes in the patterns of world trade where previously insulated domestic economies are for the first time becoming integrated into the world economy. On the basis of the World Trade Organization (WTO) estimates, the volume of world trade grew by 8 percent in 1996, fully 4 times the growth of world gross domestic product, and growth has averaged 6 percent a year since 1990 compared to less than 4 percent a year in the 1980's. Further, membership in the WTO expanded from 92 countries in 1992 to 126 member at the present; with another 30 countries including China and Russia wanting to join (Economist, vol. 341, page 21-25). Of course such positive developments in isolation give little indication of a long term commitment to economic liberalisation, but the fact is that developing nations have come to a growing realisation that their economic self- interests are best served by engagement with and participation in global commerce. The previously noted level of cross border direct investment and proliferation of regional trade agreements would further give one cause to believe that future leaders of such nations would feel compelled to continue the path towards market based economies and away from the stagnation of the recent past. If governments continue to embrace free-market reforms and the monetary discipline necessitated by the membership in global and regional trade agreements, their emerging economies should continue to grow much faster than today's rich ones, faster economic growth which in theory implies higher financial returns for investors.
Unfortunately, higher returns invariably come at the price of higher risk. The risks involved in any investment in foreign securities are generally divided into two broad categories. First, political risk refers to the uncertainty the investor faces in bring his capital home at the end of the holding period. Specifically, a foreign government might limit, tax or completely bar such transfers and in extreme cases, there is even the possibility of complete expropriation, making the political risk very large. Secondly, all foreign investments suffer exchange risk arising from the uncertainty about the future rate at which a foreign currency can be converted into the investor's domestic currency. Naturally, recent history tells us the more emerging the nation the greater the level of the proceeding risks: e.g. Mexico in 1995 or Thailand at the present. In addition to the considerable amounts of risk implied by the above factors investments in emerging economies also include accounting for lax financial practices, ropy regulations and patchy information about companies. In short, many of the factors which make American markets so efficient may be missing in less developed nations. Together the sum of such risks goes a long way to explaining the volatility of returns experienced in emerging markets but also suggests that such fluctuations will continue for the foreseeable future.
Are there less risky ways to buy a stake in these fast growing but volatile economies? One method suggested by a large segment of the financial press is to buy shares in domestic companies that have significant foreign sales. For example, Coke-Cola, McDonald's and Gillette are frequently touted as a play on third world development. The rationale being, as emerging nations become richer, consumer buying power rises and those selling branded Western goods stand to gain. However, the conclusion of numerous reports has suggested that investments in U.S based multinational were poor substitutes for direct investment in foreign stocks. Specifically, Bertrand Jacquillat and Bruno Solnik reporting in the Journal of Portfolio Management found, "the returns on U.S. based multinational firms over a ten year period had only 2 percent of their variance that could be attributed to foreign market indices. This in contrast to the 29 percent of fluctuation in returns that can be attributed to movements in the S&P 500" (winter 1978, page10). As an alternative to playing emerging markets by proxy of multinationals, U.S. investors now have the option of indirect foreign investment. American Depository Receipts (ADRs) are financial assets that are issued by U.S. banks and represent indirect ownership of a certain numbered of shares held on deposit by the institution. The advantage of ADRs over direct ownership is that the investor need not worry about the delivery of stock certificates or converting dividends from a foreign currency. Further, a report by Dennis T. Officer in the Journal of Portfolio Management found, "the average beta of NYSE listed ADRs to be 0.26 compared to an average beta of 1.01 for all NYSE listed securities over the period 1973 to 1983. In addition, the correlation of the ADRs to the NYSE composite was 0.33, whereas U.S securities had a notably higher average correlation of 0.53" (Winter 1987, page 61-65). Given these conclusions it is not surprising that a portfolio of U.S securities and ADRs had a lower standard deviation than a portfolio of purely domestic issues. Thus, in contrast to investing in multinationals, the introduction of ADRs into a portfolio brings significant benefits in terms of risk reduction, while still exposing the investor to the higher returns associated with less developed economies.
In conclusion, the past three years have yielded disappointing returns for investors pulled into the emerging market foray at its peak in 1993. The almost inevitable reduction in the rate of return on such markets from the elevated levels of the early 1990's was exacerbated by overly heightened expectations and regional (Southeast Asia) and country specific (Mexico) factors. However, the fundamental case for long-term investment in such markets remains strong. The growth of world trade, economic liberalisation and relative price levels of emerging markets bode well for continued economic expansion and hence heightened financial returns. Of course, this is not to suggest that such returns will be possible without periods of volatility. The facts are, that the very underdevelopment that causes heightened returns is also a source of great uncertainty as to the future and periodic sell-offs and will continue. For investors wishing to mitigate some of these risks while still partaking in the rewards, alternatives to direct investment exist. Such an approach would not however include the purchase of U.S. multinationals for their foreign earnings potential. This widely touted method simply exposes investors to the ever-present domestic risks, while capturing little in the way of rewards for overseas ventures. In fact a more appropriate procedure is the inclusion of ADRs into a diverse domestic portfolio. This provides a means to both a lower total portfolio beta and decreases the correlation of returns with the overall market when compared to a purely domestic portfolio. Thus, the potential for future profits is almost as good as in emerging markets themselves but with less risk. This strategy may sound less exciting than buying into a Mongolian cruise line, but then the shares may actually exist.
Chote, Robert. "Emerging Countries' Deficits Need Not Be a Problem."
The Financial Times 13 Feb 1997: A7.
The Economist. "Emerging Market Indicators." 7 Oct 1995: vol. 337, p121.
The Economist. "Emerging Market Indicators." 2 Mar 1996: vol. 338, p100.
The Economist. "All Free Traders Now." 7 Dec 1996: vol. 341, pp21-25.
Fuerbringer, Jonathan. "Emerging Bond Markets Suffering Reversal."
The New York Times 23 April 1997: C8.
Jacquillat, Bertrand, and Bruno, Solnok. "Multinationals are Poor Tools For
Diversification." Journal of Portfolio Management winter 1978: p10
Perspectives: A World of Investment Insight For Scudder Shareholders. "Looking for
An Encore to U.S. Market Performance?" Spring 1997.
Officer, Dennis T. "ADRs: A substitute for the Real Thing?"
Journal of Portfolio Management winter 1987: pp61-66.