Daniel Mminele: "Does the investment case for emerging markets still
hold?"
Address by Mr Daniel Mminele, Deputy Governor of the South African Reserve Bank, at the
Old Mutual Investor and Analyst Showcase Dinner, Cape Town, 4 December 2013.
* * *
1. Introduction
Good evening ladies and gentlemen and thank you to Old Mutual for inviting me to say a few
words tonight, just as another year with its share of uncertainties and challenges is drawing
to a close. The topic chosen for our discussion, namely whether or not there is still a case for
investing in emerging markets (including South Africa) may have sounded incongruous two
or three years ago, when emerging countries were at the forefront of the global economic
recovery, and capital flows into the emerging world had resumed at a strong pace following
the 2008-09 financial crisis. However, the last twelve months in particular have proved more
challenging for securities markets in the emerging world, and it is the seriousness and
durability of these challenges which I will try to assess tonight.
2. The changing role of emerging markets in global growth
The historical case for portfolio diversification into emerging market assets has long been
based on the growth outperformance of emerging market countries. As these countries grew
faster than their developed counterparts, reflecting either favourable demographics, large
investments in human and physical capital, strong productivity gains, better governance or a
mix of these, returns on invested financial capital were expected to be elevated. In turn, this
justified faster growth in prices of emerging market equities. Furthermore, as income levels
converged towards those of more developed economies, support for stability-oriented
policies - and, consequently, lower and more stable inflation - increasingly became the
norm, enabling a reduction in the risk premium embedded in these countries' fixed-income
markets. Finally, stronger productivity gains called for an appreciation of emerging market
currencies, at least in real terms, over the long run. For most of the past decade, empirical
evidence supported this paradigm: For example, between 2002 and 2012, the Morgan
Stanley Capital International (MSCI) index for emerging market equities outperformed its
global counterpart by 300 per cent, while returns on local currency emerging market bonds
were 40 per cent higher than those on US Treasuries over the period.
Yet, something seems to be changing. Emerging market economic growth is still outpacing
that of the developed world, but the gap is narrowing. In its October 2013 World Economic
Outlook, the International Monetary Fund (IMF) projected that growth in emerging markets
would slow from 4,9 per cent in 2012 to 4,5 per cent this year and pick up to 5,1 per cent next
year, whereas at the same time, developed economies would accelerate from 1,2 per cent
this year to 2,0 per cent in 2014. Such a narrowing, albeit a mild one, in the "growth gap" is
nonetheless surprising as in the past decade or two, recoveries in the developed world
generally saw the emerging economies outpace advanced economies. In a word, global
recoveries used to leverage the emerging market performance, rather than undermine it.
Why is this happening? It is hard to pinpoint a single cause. But, among others, the
performance of exports in many emerging economies has been poor, by historical standards,
over the past eighteen months, suggesting (at least in some sectors) a loss of world market
share. Also, in the current year, the co-existence of strong rates of credit growth and slowing
real GDP growth in several large emerging market economies has raised concerns about a
declining efficiency of invested capital. Separately, efforts by Chinese authorities to
rebalance economic growth towards a more consumer-oriented model has prompted
expectations that growth in China will in future be less intensive in industrial commodities,
with negative implications for the major exporters of these commodities.
The big question is how much of the recent developments represent underlying structural
changes, or whether some of these factors will prove cyclical - for instance, that exports will
revive once the developed world's recovery is more solidly entrenched. There are some
issues that point to a structural component. Firstly, one tool through which developed
economies are fostering economic improvement is by restoring competitiveness, be it via
cost and price disinflation (as in the case of the euro zone's periphery) or by allowing
currency depreciation (like in Japan). Secondly, a difference between the current situation
and the early 2000s - when the recovery saw emerging market growth outpace global
benchmarks - is that the real effective exchange rates of emerging market currencies are
not, on balance, as depreciated as they were at the time. Thirdly, there are increasing
indications that the moderation in economic growth in the emerging world has some lasting
causes, for example less favourable demographic patterns. It is significant that the IMF's
potential
estimates for economic growth in all the five BRICS countries are lower, in 2013,
than similar estimates made in 2011.
3. The likely impact of declining global liquidity
The impact of somewhat less favourable fundamentals has, of course, been compounded by
concerns that the ample liquidity made available in recent years to fight the global crisis will
gradually be withdrawn, perhaps in the not-too-distant future. The announcement by the US
Federal Reserve in May that conditions would probably soon warrant a tapering of its asset
purchase programme - which incidentally does not equate to a reduction in global liquidity,
merely to a phasing down of additional injections - quickly resulted in a sharp rise in the risk
premium embedded in most emerging market assets. Since Chairman Bernanke first talked
about tapering on 22 May 2013, the JP Morgan index of emerging market currencies has lost
7.5 per cent of its value versus the US dollar; the Emerging Market Bond Index (EMBI) local
currency index has fallen by around 2.4 per cent at the same time as the EMBI-plus
sovereign spread of US dollar-denominated debt over US Treasuries increased by close to
100 basis points; and the MSCI Emerging Market equity index has fallen by 4.0 per cent,
even as the MSCI World index of global equities continued to power ahead, gaining 6.0 per
cent over the period.
What will happen, then, when global central bank liquidity starts declining in earnest?
Admittedly, the response to tapering talk since May need not necessarily be a guide to future
market moves, as the reduction in the Federal Reserve's asset purchases is probably by now
discounted to a much larger extent than it was before Chairman Bernanke spoke to
Congress in May. To the extent that the Fed does not again surprise markets, but instead
manages to stabilize expectations embedded in the longer part of the US yield curve, for
example via the continued and effective use of its forward guidance, the impact on the global
asset price constellation could be more benign than it has been so far this year. But how
much is priced-in, nobody really knows.
Nonetheless, the strong correlation seen since the second quarter of 2013 between the
exchange rates and bond yields of emerging countries (especially those seen as the most
vulnerable to a reversal of capital inflows, because of more fragile domestic growth or
external account fundamentals) and US Treasury yields, does highlight the vulnerability of
the former to a further backup in the latter. Notwithstanding central bank efforts at anchoring
long-term rate expectations, it seems difficult to imagine that a reduction in global liquidity -
at a time when non-resident demand for US bonds, in particular, has been waning - would
have no significant impact on US or core European yields. International estimates of "term
premiums" embedded in longer-term bond yields did suggest that quantitative easing policies
had compressed these premiums to unusually low levels; in turn, as prospects for an
unwinding of quantitative easing emerged, they started to normalize. Furthermore, term
premiums have shown some correlation across both developed and emerging bond markets,
in particular since they began to rise from May 2013 onwards.
4. The case for (still) investing in emerging markets
Risks hanging over emerging market assets, however, do not mean that the case for
investing in such assets is closed. First of all, while the growth out-performance of emerging
countries relative to the developed world has been dwindling, this should not obscure the fact
that the gap, while narrowing, remains positive, and that emerging markets remain the
biggest contributors to global growth. Demographic trends, productivity gains, increases in
the stock of capital remain conducive to a stronger growth performance of emerging market
countries in the medium to long term. Even countries that have shown a relatively strong
degree of convergence with living standards of the developed world can still out-perform the
latter, as the case of Korea and Taiwan shows.
Similarly, emerging countries continue to display, on balance, better fiscal or external metrics
than their developed world counterparts, whether one looks at current account balances,
public deficits or ratios of public and private debt to GDP. Rather than the developments
following Mr Bernanke's comments in May 2013 representing an "emerging market crisis", as
some may want us to believe, what is probably a more correct characterization of the
developments is a correction or re-pricing in the wake of expected normalization of global
monetary policy and uncertainty around the speed of such normalization. What seems to
further underpin the emerging markets investment case is much stronger fundamentals when
compared to previous episodes of emerging markets coming under pressure, such as in the
late 1990s, or even more recently in 2008. Substantial progress has been made in the last
two decades towards more flexible exchange rates, reserves have been accumulated on a
grand scale, fiscal positions are healthier than in many advanced economies, all of these
making emerging markets overall more resilient. With regard to the more cyclical component
of the recent developments, without underplaying the need for structural reform in some
cases, one could even draw a more constructive conclusion of current developments, namely
that depreciating exchange rates, and moderation in growth patterns may actually be
testimony to how responsive these economies have become, and can adjust to changes in
the underlying fundamentals.
Furthermore, global investors may at present be relatively under-weight in emerging-market
securities, strengthening the case for out-performance of the latter over the medium term.
Private surveys of US and EU pension funds do suggest that their allocation to
emergingmarket debt has remained stable and relatively low, as a share of total assets under
management, in recent years, even as the share of emerging market bonds in world market
capitalisation continued to grow. In particular, global investor allocations to local-currency
bonds of emerging market economies remain low, in part because of historical reasons of
liquidity which nonetheless fade over time as emerging economies increasingly expand the
size and maturity of their local bond market.
That said, not all emerging countries retain sustainably stronger fundamentals than their
developed world counterparts, and growing divergences within the broad emerging market
bloc, coupled with the likelihood of less abundant liquidity over the next few years, suggest
that differentiation between respective emerging markets could increasingly become the
norm in coming years. Whereas the immediate post-recession years had seen a strong
cross-correlation between the performances of different emerging market assets, as they
shared common drivers in the form of liquidity injections and interest rate expectations in the
world's major economies, such correlations have already started to wane in 2013. Country
differentiation gradually began to replace the proverbial "risk on, risk off" trading patterns of
the earlier period. Countries with relatively weaker growth, inflation and external account
metrics saw their currency, bond and equity markets under-perform those with more solid
fundamentals. Therefore, it may not be helpful to lump together countries and call them "the
fragile five", when underlying dynamics in these countries could be quite different, even if
they present similarities when one looks at budget deficits and current account deficits.
5. South African assets under this new paradigm
This allows me to conclude with a few words on our domestic situation. Domestic financial
markets have faced significant challenges since the second quarter of this year. The rand
has extended a depreciating trend that began in the latter half of 2011, and lost about 12 per
cent on a trade-weighted basis since early March, declining to levels last seen in late 2008,
at the height of the global financial crisis. The yield on the benchmark R186 long-term bond
has risen by more than 100 basis points, even as domestic short-term rates remained
anchored by the absence of a change in the Reserve Bank's repurchase rate, while the CDS
spread on five-year sovereign South African debt also widened, generally by a larger amount
than those of countries enjoying a similar rating to South Africa. The domestic equity market
has been the exception to this rule, although this partly reflects the "rand hedge" qualities of
certain sectors or stocks which, because of the dollar pricing of their outputs or the
international diversification of their operations, tend to benefit from a depreciation of the
currency.
We cannot be under the illusion that the poor performance of domestic financial markets
since the beginning of this year is a mere consequence of a less favourable international
backdrop. Domestic socio-economic fundamentals also play a part in investment decisions of
global buyers of South African securities. Phases of rand under-performance relative to other
large emerging market or commodity-linked currencies have frequently coincided, of late,
with disappointing foreign trade or current account data releases; similarly, episodes of
labour disputes are often accompanied by a poor performance of the local currency and
credit spreads. More generally, investors seem to query whether the growth prospects of
South Africa will be sufficient to meet, over time, the economic aspirations of its citizens and,
in so doing, cement public support for the stability-oriented macroeconomic policies which
investors have long regarded as a "constant" of the political landscape since the advent of
democracy in 1994.
However, one should not so easily forget the great many strides South Africa has made on
the macroeconomic front, reflected by greater macroeconomic stability and longer upswings
in the business cycle since the advent of democracy. The adoption of an inflation-targeting
monetary policy framework in 2000 came with many benefits - contributing to a decline in the
level and volatility of inflation and nominal interest rates, improving the transparency and
accountability of the central bank, and therefore also its credibility. South Africa became
increasingly integrated into international financial markets, contributing to the growth and
development of its own domestic financial markets and financial infrastructures in terms of
sophistication, depth and liquidity, thereby helping to boost growth and improve the country's
resilience against external shocks. The policy and institutional framework similarly remain
strong. It is also as a result of this underpinning for the South African investment case that,
over the years, South Africa has been included in a number of bond indices tracked by
international investors, such as the JP Morgan Emerging Market Bond Indices and the Citi
World Government Bond Index.
The strides we have made as a country are borne out by favourable rankings in a number of
competitiveness reports. Overall, South Africa is ranked 53 out of 148 in the 2013/14 World
Economic Forum Global competitiveness report; ranked in the top 15 worldwide in the 2012
Emerging Markets Opportunity Index; first in economic competitiveness in the Africa
Competitiveness Report (taking the lead in financial market development, technological
readiness, market size, business sophistication and innovation); and 39 out of 185 countries
in the World Bank's Report on Doing Business.
South Africa is respected for its good corporate governance - ranking first for ethical
behaviour of firms; efficacy of corporate boards and protection of minority shareholders in the
Global Competitiveness Index. We perform particularly well in a number of areas: quality of
institutions; intellectual property protection; property rights; efficiency of legal framework; and
accountability of private institutions. These rankings are a clear indication of South Africa's
economic and financial potential.
That said, there are no doubt challenges that we confront today as a country and those
challenges are reflected in the somewhat weaker investor sentiment. There is an urgent
need for action on structural reforms, focus on quality education and skills development;
infrastructure investment; to name a few. The National Development Plan sets out a good
framework for dealing with these issues and the implementation thereof would help place the
country on a faster and more sustainable growth path. Tackling these challenges requires a
collective effort by players inside and outside government and a realisation that trade-offs will
be necessary, and that the more difficult challenges cannot be addressed in a manner that is
entirely painless for everybody.
What role can, and should monetary policy play in supporting investor confidence in South
Africa's fundamentals? Admittedly, it is the nature of financial markets that perceptions of risk
evolve over time, resulting in at least some degree of price volatility, even in those markets
perceived as among the safest. Policymakers cannot completely eliminate financial market
volatility. Yet in the recent past, some emerging countries have used specific tools to try and
limit the extent of such volatility. One should however remember that the structures of
financial markets differ across countries, and hence a policy tool that appears appropriate in
some jurisdiction may not necessarily be the most desirable one in a different country.
Furthermore, empirical evidence does not, so far, suggest that the volatility of South African
financial assets has meaningfully diverged from those of markets in countries where such
policy tools have been implemented.
It is, however, important that investors remain assured and convinced of the firm commitment
of South African authorities to price stability and sustainable public finances, irrespective of
the challenges that the country faces in the pursuit of sustained economic growth and
development. In that respect, the Bank's commitment to flexible inflation targeting, monetary
policy transparency and predictable implementation, remain crucial to limiting any rise in
financial market uncertainty and volatility.
The Monetary Policy Committee at its November meeting judged that an unchanged policy
rate was consistent with its mandate at this stage. In order to maintain the integrity of the
inflation targeting framework, however, it would not hesitate to take appropriate action,
should the medium-term inflation outlook deteriorate significantly. At the same time, a
reduction in public deficits as per the framework laid out in the October 2013 Medium-Term
Budget Policy Statement, together with the implementation of measures agreed upon in the
National Development Plan, aimed at unlocking the country's longer-term growth potential,
would substantially assist the Bank in carrying out its mandate of price and financial stability,
in the interest of sustained economic growth and development.
6. Conclusion
Let me then finish by answering the question of whether there is still a case for investing in
emerging markets with a "yes". While challenges remain and headwinds in the form of
uncertainties around Fed tapering, lower growth in key emerging market economies, and
continued volatility are likely to be with us for some time, and the need to address certain
structural challenges by emerging economies is beyond question, the much better
fundamental backdrop of emerging markets and continued prospects of higher growth than in
advanced economies, especially in regions such as Sub-Saharan Africa, appear to suggest
that it would be a mistake to write off emerging markets. By rather adopting a somewhat
medium to longer-term investment horizon with appropriate diversification strategies, and
looking through some of the temporary turbulence, investors that maintain their loyalty to this
asset class are likely to reap the benefits. Emerging markets appear to be adjusting both
cyclically and structurally from spectacular levels of growth observed previously to more
sustainable levels. This should continue to support a steady investment case.
Thank you.
Selected bibliography
World Economic Outlook - Transitions and Tensions, International Monetary Fund, October
2013.
"Reviewing the Case for EM Local Debt - Structural Strength, Cyclical Headwind", The
Rohatyn Group, August 2013.
"Will DM's Recovery be EM-friendly?" Emerging Market Macro Outlook and Strategy, Citi
Research, 27 September 2013.