Emerging Markets
Curtis
Mewbourne Watch
August 2009
Emerging Markets
in the New Normal
At PIMCO’s most recent secular forum we review the critical mass of this transforma-
analyzed the significant changes to the tion and the implications this has for the
global economy and concluded we were valuation of the U.S. dollar and its role as
entering a New Normal. This New Normal the global reserve currency.
will mean lower potential growth for the
global economy overall and especially so Voting or Weighing Machine?
for the highly levered developed economies. Whether financial markets are voting
For the emerging economies this presents a machines or weighing machines2 the chart
challenging environment, with lower export below is eye opening. China’s stock market
demand and a reversal of leverage induced capitalization is now larger than that of
global capital flows. But it also presents sig- Japan, the second largest economy in the
nificant opportunities, not only to shift from world. Just three years ago, in 2006, Japan’s
export led growth to domestic demand but
also to strengthen their position within the Stock Market Capitalization
6
new economic order.
Jan-2008
We believe that several key emerging econ- 5
omies are well advanced in the process
4
of making that transition. While the U.S., Jul-2009
U.S.$ Trillion
Europe, and Japan are still economically the
3
largest and most dominant economies, these
economies are reaching the tipping point1 2
of global economic impact. This article will
1
Japan
Emerging Economies Becoming China
“Locomotive” of Global Growth 0
10 Jan-06 Jan-07 Jan-08 Jan-09
Advanced Economies GDP Growth
Source: PIMCO
8 Emerging and Developing Economies Chart 2
GDP Growth
6 market capitalization was 12 times the size of
4 China’s. In retrospect a buy China/sell Japan
Percent (%)
2
trade was about as close to a “no brainer” as
financial markets offer. Four trillion dollars
0
of profits were available for investors who
-2 stuck with this simple theme.
-4
Some readers may perhaps fear that yet
-6 another asset bubble is forming, and that
2007 2008 2009F 2010F
the growth in the Chinese market has come
Source: IMF World Economic Outlook 2009 too far too fast, which of course is pos-
Chart 1 sible. At 25 times forward earnings and
Emerging Markets Watch
3.8 times price-to-book, the Shanghai Stock Projections of Global
Exchange Composite Index is far from cheap Consumption Growth
by traditional measures, and thus financial
markets are likely reflecting more of a “voting One analogous way to think of an economy
machine” aspect of future expectations than a is as a company with four major divisions,
“weighing machine” measure of current value. namely, consumer, business (investment),
But the fact is that we are witnessing real government, and international (net exports).
time indicators of significant changes in the For a company with limited domestic
global economy, with China clearly continuing customers (consumer, business, or govern-
its meteoric rise in terms of global economic ment), a winning strategy can be to initially
importance. It is not surprising China’s market produce goods for the export markets,
capitalization is larger than Japan’s, given that and look to grow the other divisions over
the Chinese economy will probably surpass time as demand picks up. As shown in the
Japan to become the second largest economy graph below, that domestic demand is now
in the world next year, measured in current starting to pick up, with enabling condi-
exchange rates.3 tions in place following years of structural
reforms and balance sheet improvement.7
China is clearly the largest emerging econ-
omy, but by no means is the phenomenon Following this simple construct, economies
limited to China. Indeed in terms of GDP, with large domestic consumer and business
emerging market (EM) economies account for (investment) sectors – like in China and India
seven of the top twenty countries4, and repre- with 30% of the world’s population – may
sent the component that is growing the fastest. have a key advantage. Take for example the
The rest of the BRICs5 share some of the same auto industry: Chinese auto sales are poised to
characteristics that are significant comparative
advantages in the New Normal, for example, Global Share of Consumption
low labor costs and extremely low levels of (% share of global
2007E 2008F 2009F 2010F 2015F 2020F
consumption)
consumer debt. They also have large popula-
U.S. 30.2 29.3 28.3 27.4 23.5 20.8
tions, so domestic demand can truly move the
needle on a global scale. Non-Japan Asia 12.1 13.6 15.5 17.1 25.8 32.3
China 5.3 6.4 8.0 9.3 16.4 21.1
For countries to become and remain domi-
nant in the global economy they must reduce Japan 8.2 7.9 7.7 7.4 6.5 5.8
their dependency on others (export demand) Germany 5.6 5.5 5.3 5.1 4..3 3.8
and develop their own sources of sustainable U.K. 5.0 4.9 4.8 4.6 4.0 3.7
demand (particularly domestic consumption).
France 4.2 4.1 3.9 3.8 3.2 2.9
Thus for large systemically important econo-
mies, export led growth is a means rather than Italy 3.6 3.4 3.3 3.2 2.7 2.3
an end, and the transition to domestic demand NIE 4* 2.9 3.0 3.0 3.0 3.1 3.1
is underway. The large (~$580 bn) government India 2.0 2.2 2.4 2.6 3.9 5.3
stimulus program in China has been a contrib-
Spain 2.4 2.3 2.2 2.2 1.9 1.8
uting factor, keeping GDP above 6%. But India
too has been able to maintain growth around ASEAN 4** 1.8 2.0 21.1 2.1 2.5 2.7
5%, without such a large program. A recent Canada 2.3 2.3 2.2 2.1 1.9 1.7
analysis by Credit Suisse6 shows that Chinese
Source: Credit Suisse
consumption is already the second largest con- Note: Data sorted by year 2010
tributor to global consumption, and that China *Includes Hong Kong, Korea, Taiwan and Singapore
and India will be the first and fourth largest **Includes Indonesia, Malaysia, the Philippines and Thailand
contributors by 2020. Chart 3
August 2009 Page 2
exceed U.S. sales (chart below). The BRICs have are freely convertible. Each of these coun-
10 times the population of the U.S. and less tries has some system of capital controls that
than 3% of the population own automobiles, so significantly limit foreign exchange trans-
the potential for growth is simply huge. actions. Governments use capital controls
to keep control of their currencies by not
One of the most powerful and poten-
tially profitable investment implications allowing currency to leave the country9 freely
likely to result from emerging economies and by requiring foreign entities to exchange
reaching critical mass is the future value of only with the central bank or its agents. On
the U.S. dollar, which has been the undis- the trading floors of the large international
puted global reserve currency since the end banks you can trade U.S. dollars, Japanese
of WWII. Many thoughtful and influential yen, euros, British pounds, Mexican pesos
market participants expect the U.S. dollar and Polish zlotys and dozens of other curren-
to continue to play that role, if for no other cies for delivery into your bank account, but
reason that there are no viable alternatives. if you want to buy or sell Chinese renminbi,
They will likely point to the euro (€)8 as suf- Brazilian real, Indian rupees or Russian
fering from a lack of political union among rubles you can only do so in the “offshore”
member states and the significant finan- derivative market, where buyers and sellers
cial crises among peripheral countries. The pair up with no physical currency changing
British pound, notwithstanding the fact that hand, and all gains or losses are settled in a
it was the global reserve currency for most of different agreed currency.10
the 18th and 19th centuries, is not a realistic
contender given the small size of the U.K. So while it is true that no emerging curren-
economy. Nor is the yen, with the dimin- cies have yet reached critical mass as a viable
ishing economic status of Japan, following replacement, there are many reasons to expect
two decades of economic stagnation. a secular decline in the value of the U.S. dollar.
Notably absent from the list of alternatives As seen in the following chart, emerging
above are the currencies of the BRIC coun- countries hold the lion’s share of international
tries. Why? Because none of these currencies reserves, mainly in the form of U.S. dollars
and to a lesser extent euros. They appear to
be increasingly concerned that the weak-
U.S. and China ening U.S. economy and banking system, the
Automobile Sales increase in money supply and other factors
20,000
may reduce the value of the dollar over time.
18,000
Notably, they have been voicing concerns in
16,000
international forums like recent G8 meetings,
14,000
and they have taken some (perhaps small)
12,000
steps to reduce dependency on the U.S. dollar.
000s Units
10,000
8,000
China for example has entered currency swap
6,000
arrangements with a number of countries11 so
that trade financing can be negotiated in ren-
4,000
China
U.S.
minbi as opposed to dollar terms. In addition,
2,000
several countries have signed up to replace
0
part of their foreign currency reserves with
D l-08
M -08
9
Fe -07
Ju 08
Ju -06
N -06
Ap -06
Se -07
M -04
Au r-05
Ja 05
O 04
Fe -02
Ju 03
M -03
Se -02
Ju -01
N -01
Ap 01
D -03
-0
b-
g-
-
b-
-
new bonds issued by the IMF and denomi-
ec
ay
r
p
n
n
ov
ay
ct
ec
ov
r
p
n
n
l
a
Ja
Source: PIMCO nated in SDRs (Special Drawing Rights), a
Chart 4 basket of currencies.
Page 3
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But It’s Your Problem12 combination with other factors, that likely PIMCO with Facebook.
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60 the EM currencies. Accordingly investors twitter…
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% of World FX Reserves
55
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EM Economies
50
Advanced Countries
45
Curtis Mewbourne
Managing Director, Portfolio Manager
40
35
97 99 01 03 05 07 1
In his book of the same name, Malcolm Gladwell says
Source: PIMCO, as of June 2009 a “Tipping Point is the moment of critical mass, the
Chart 5 threshold, the boiling point.”
2
To paraphrase, in the short term, the stock market behaves
Capital must flow somewhere, and recent like a voting machine, but in the long term it acts like a
data suggest that the patterns of the pre- weighing machine, Graham and Dodd, Security Analysis
(McGraw-Hill, 1934), page 23.
vious decades, when capital flowed out 3
IMF forecasts of nominal GDP measured in $U.S. at
of emerging countries and back into core current exchange rates, World Economic Outlook April
countries has to some degree reversed. 2009. China became the second largest economy in the
Clearly the U.S. dollar benefitted from world in purchase power parity (PPP) terms in 2001
according to IMF data.
a strong flight to quality bid during the 4
China, Russia, Brazil, India, Mexico, Korea, Turkey per
global banking crisis. However, recently IMF World Economic Outlook 2009.
we have witnessed a reversal of those 5
BRICs include Brazil, Russia, India, and China.
flows, arguably at least in part due to con- 6
Credit Suisse, “China’s Economic Outlook,” Dong Tao,
cerns that the massive amounts of U.S. Chief Economist, Non-Japan Asia Economics Research,
dollar liquidity produced in response to the July 16, 2009.
crisis. Indeed, in emerging countries we are
7
See previous EM Watch articles for analysis of structural
and institutional reforms across EM countries at http://
seeing some central banks intervening to www.pimco.com/LeftNav/ContentArchive/Default.htm
limit appreciation of their currencies as cap- 8
The € was introduced as an accounting currency
ital flows back into their economies. These on 1/1/1999 with coins and bills entering circulation
preliminary signs of a reversal in the tra- 1/1/2002.
ditional pattern of capital flows during
9
Small amounts of notes and coins are tolerated but
foreign individuals and companies cannot, for example,
a deleveraging cycle may well mark an exchange those currencies or deposit them into a
important shift in currency preferences. bank account.
10
The Non Deliverable Forward (NDF) market under
And while we have not yet reached the point ISDA agreements.
where a new global reserve currency will 11
Brazil, Hong Kong, Indonesia, Korea, Malaysia, Belarus
arise, we are clearly seeing a loss of status and Argentina.
for the U.S. dollar as a store of value even in 12
John Connally, Treasury Secretary under Nixon.
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