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Economist Dambisa Moyo takes a look at how China is shaping emerging markets and at the growing “schism” that is developing between developed and emerging markets in this article which is reproduced under the fair Dealing provisions of the Copyright Act from the CFA Institute:
http://www.cfapubs.org/doi/pdf/10.2469/cfm.v24.n4.12
The techniques for doing business in emerging markets that Dr Moyo mentions early on in the article are the traditional Chinese ways of doing business so there is some comfort level for them in Africa, especially.
The danger of commodity based conflicts might merit a whole new thread, if one doesn't already exist.
http://www.cfapubs.org/doi/pdf/10.2469/cfm.v24.n4.12
New Frontiers
Investors ignore key trends in frontier markets "at their peril," says economist Dambisa Moyo
By Jonathan Barnes
CFA Institute Magazine July/August 2013
Chinese commodity investment and trade are reshaping frontier markets and emerging economies, but many investors are overlooking an even bigger story, according to Zambian-born economist Dambisa Moyo, author of Winner Take All: China’s Race for Resources and What It Means for the World. Although China is a major theme in the story, its contribution is less significant than the growth of domestic demand in these markets. Investors who focus only on the commodity aspect stand to miss out on opportunities for alpha generation. Moreover, a structural “schism” is forming between developed and emerging markets, with profound implications for investors.
In this interview with CFA Institute Magazine, Moyo, who recently spoke at the 66th CFA Institute Annual Conference in May, discusses key developments and trends in frontier markets. As she explains, common misconceptions can lead investors into trouble, including the tendency to “conflate the idea of risk and uncertainty when they talk about emerging economies” and the misinformed notion that developing markets are highly illiquid. Moyo also highlights the danger of escalating conflicts over natural resources.
What story are you seeing in developing markets?
A lot of people are quite focused on private equity when thinking about emerging or frontier markets. But the most interesting story is really the public markets, because I think that’s where there is a blind spot for most investors. That’s where I think there is significant opportunity, and we’ve already started to see that some of the savviest investors are really putting money to work in these markets. There is a lot of opportunity to invest and generate superior, uncorrelated returns in a broader global portfolio.
Many frontier markets—just looking at the macroeconomic theme—have a solid capital base in terms of debt and deficits, strong labor dynamics (in terms of a young population), and a really compelling story around productivity. Those are three key ingredients that drive economic growth: capital, labor, and productivity.
What I’m suggesting is that in the public markets, trading of equities and fixed income is rapidly increasing. I think the returns in the macro story are reasonably well known, but where I see real change in the thinking is around risk management and liquidity. Those are the two key things.
What is changing in regard to risk management?
I think people traditionally conflate the idea of risk and uncertainty when they talk about emerging economies and frontier economies in particular. What we’re seeing with savvy investors is that there is a much clearer delineation between risk (which is measurable, which you can manage and hedge against) and uncertainty (which is obviously what is immeasurable—the whole idea of tail risk, of not being able to measure these outcomes). What has happened is that there has been a move away from this idea of uncertainty and toward the idea of there being significant opportunities in risk management and, therefore, the ability to put
money to work in these markets.
And with regard to liquidity?
In regard to liquidity, people have tended to think these are highly illiquid markets, where there is really no opportunity to write big checks or the opportunity to go both long and short.
Actually, we’ve seen a significant increase in the ability to trade large-ticket items. So, for example, it is not unheard of to be able to put US$10 million or US$20 million to work in a single name, in places like Nigeria or Kenya or the Philippines or Sri Lanka. Also, you can go short as well as long in these markets. There’s not much in terms of a developed knowledge base [of these areas]. It’s just something that people who are in the know are doing much more.
Are investors using new techniques to measure risk?
It’s actually age-old techniques being applied more thoroughly. If you’re going to invest in these markets, you need to have very good underground contacts—a network that can help you understand some of the evolutionary challenges these countries face as they go from largely state-owned countries to market-driven economies that are more democratic.
Investors who have the underground contacts—which is just good business in terms of risk management—will do better than those who don’t. You could ask, “Is that the new risk management?” No, it’s not. That’s how people do risk. They want to touch and feel, to look into the eyes of the people they’re doing business with. That is really where I think there have been leaps and bounds.
People now feel comfortable to travel to these places and spend time with the business owners and the business managers and get a better handle on what is going on. That traditionally was not the case, because these countries and these places were viewed as far too risky, far too uncertain, a “we don’t go there” kind of thing because “it’s too worrisome.” That story has changed quite considerably.
Also, to the extent that you’re getting much more market data, much more information and pricing information, then traditional model analysis, technical analysis, and fundamental analysis also become much more applicable.
How has Chinese investment impacted developing regions?
There are few countries that have not benefitted from China’s campaign—everyone from the United States to countries across Africa and South America have all benefitted from the Chinese campaign, whether it’s through investment in debt (as in the case of the U.S.) or investment in infrastructure. But there’s an impact also in some of the tradable markets. For instance, China’s Industrial and Commercial Bank of China (ICBC) bought 20% of South Africa’s Standard Bank, one of the largest banks in Africa, in 2007. I think you would be hard pressed to come up with a country that has not benefitted from China.
Are there other examples?
My book Winner Take All is littered with examples of Chinese investment in commodities. I talk about the purchase of Mount Toromocho in Peru, which is basically a copper investment that the Chinese made in 2007. I talk about the deals that have been struck in Brazil, with the Chinese investing in agriculture there, and in places like Africa. I also talk about swaps that the Chinese put on in Russia and Pakistan in return for access to oil and uranium, respectively, which are very specific investments that could be very helpful.
Having said that, is China a key piece of the story?
Yes, it is. Is it the only piece? No, it’s not, because many of these economies are also very quickly seeing an increase in domestic demand. Their own local populations are actually now getting a foothold on the economic ladder. A lot of the change we’re seeing is due to China, but more significant is the domestic-demand theme.
How compelling are uncorrelated returns in frontier markets?
One of the main stories is this whole idea of superior, uncorrelated returns that you can garner by investing in the emerging markets. If you were to characterize the situation in developed markets right now—using the lens of capital and productivity—we know that they are struggling under significant debts and deficits. They’ve got serious aging-population concerns, not just in terms of the quantity of labor but also the quality of labor. If you look at the OECD statistics, you can see that the quality of labor is deteriorating in many developed markets. Then there’s the issue of productivity. You have countries like Britain, where in the past decade they’ve seen a decline in productivity in every single sector.
If you look at the emerging market or frontier economy, the story is quite different. You see strong, solid dynamics, a very credible, positive upswing in labor, both in quality and quantity and in productivity. The democratic processes are including more transparency, less corruption, and countries are importing technology that can help them. So that in and of itself is a schism.
The correlation between the developed markets returns and the bigger emerging market returns is around 0.9 by some measures. The return correlation between developed markets and frontier markets is closer to 0.7, which obviously is still significant but it’s relatively small and obviously makes a compelling story from the diversification of a portfolio point of view.
Has China set an example in how to engage frontier economies?
Of the world’s population, 90% live in the emerging market. In many of these countries, up to 70% of the population is under the age of 25. It’s a very young population, and very, very impoverished. These countries need trade, they need investment, and they need job creation. The Chinese mode of engagement—where they are interested in forging a relationship of investment and trade, creating jobs, and building out infrastructure—is much more beneficial for longer-term development than an attitude or an approach that focuses much more on supporting these countries in the short-term through aid.
I don’t think it is rocket science. There is not a single country in the history of the world that has achieved economic growth and reduced poverty in a meaningful way by relying on aid to the extent that many emerging countries rely on aid today. So it is not a mystery to me that good trade and engagement, solid foreign direct investment, capital markets development, and so forth are key pillars of a strategy to create economic growth. That is really what many people are describing as China’s approach for engagement.
Do you see Western countries following China’s lead?
Yes, absolutely but obviously to a much lesser degree, because one key aspect of China’s approach is that it’s got deep pockets. But if you go across the emerging world, it is pretty clear that India, Turkey, and others have adopted the approach to some degree. Across Africa, you see a lot of Turkish, Lebanese, and Russian investment—what you would call South–South investment. It is a big piece of the economic development story that’s going on across the emerging world.
It is worth pointing out that the ongoing financial crisis in the U.S. and Europe means that many of the developed markets have been back-footed. But the hope is that if they were to remedy their problems, then they also would be part of this investment and trade story.
What’s the likelihood of China becoming a monopsony in commodities markets?
The idea of a monopsony is about China’s market power in publicly traded markets. It’s not necessarily about their impact on a frontier economy. Are they able to influence (inadvertently, I would say) the market price of different commodities? The answer is yes for both copper and coal, for example. Many market traders would argue that, even today, the Chinese influence on the ability to be price setters is quite significant.I think that the ability to be a price setter and to have pricing power in the broader markets is a piece of the puzzle, but I don’t think it has to do with China’s engagement with frontier economies per se. Australia is the largest recipient of Chinese foreign direct investment. And as we speak today, the China National Offshore Oil Corporation (CNOOC) is about to close its largest transaction ever in the commodity space with a US$15.1 billion dollar purchase of Canadian oil producer Nexen. Those are both nonfrontier economies, but the activity obviously will have significant implications for the markets.
What does the evolution of the BrIC markets tell us about the path for frontier markets?
One of the case studies I love is the story of Turkey. Turkey has quickly changed from what was arguably a frontier economy into a much more developed market economy. Within 7–10 years, Turkey went from an economy where the cost of funding to do a trade would be about 8% and the maximum size you could do in a transaction for one stock would be about US$5 million to one where the funding cost is about 0.5% or 1% and you can very easily write a ticket of up to US$200 million dollars to buy or sell into a particular stock in Turkey. That shows how much liquidity has become available.
To me, that transition (from being a relatively niche market, quite small, to becoming a market where you can actually put on massive trades for reasonably aggressive funding) is exactly the sort of path that I expect we will see amongst the frontier economies in the years to come.
What about specific investments in frontier markets?
One of the big misunderstandings about many emerging economies, particularly in Africa, is that people think it is a big commodity trade. That is completely wrong. Over 85% of the stocks that trade in Africa (there are about 20 stock exchanges and over 1000 stocks) are non-commodities.
There are stocks in banking, logistics, telecommunication, the retail sector, and consumer goods that have really captured the growth theme that we’ve talked about already. That’s my big point—you miss out if you think it’s just a commodity story.
The second point is I believe very strongly that you don’t want to just be going long in these markets. You also want to be able to short. Some of the worst performers last year were Mongolia and the Ukraine (on the back of the difficulties that they both had in their political environment). The markets are now mature enough to be able to put on positions that reflect those negative outcomes. Fortunately, you now are able to short the market for many but not all of the frontier economies.
I don’t like to be a stock picker, but I will say that in virtually all of these frontier economies there are two sectors that I like in particular. One of them is banks, which are the foundation of economic development. There is real significant upside around banking and insurance. If you think about some of the Nigerian banks, you can see the theme
being put to work as a practical example. The other area that I really like a lot is construction.
How prevalent are resource conflicts in these regions?
In the U.S., the National Security Agency (NSA) put out a report in February 2012, basically articulating concerns and real risks around commodity-based wars, particularly emanating from water scarcity. In Winner Take All, I have a couple of tables at the back [of the book] that look very specifically at which region and what countries are already engaged in skirmishes, civil wars, and so on around commodity scarcity.
Since 1990, there have been over 20 wars around commodity scarcity. If you look at some of the work by Michael Klare [professor of peace and world security studies at Hampshire College and author of The Race for What’s Left: The Global Scramble for the World’s Last Resources, there is a lot being done right now in forecasting where some of the big wars could come from in the years to come, borne out of scarcity of natural resources.
Am I worried about this being a big piece of the puzzle? Yes, I am worried about increased conflicts. It is already happening today, and it could escalate. Demand pressures, such as population, increases in wealth, and urbanization, are just not matching with the supply of water, arable land, minerals, and energy. This type of concern around natural-resource conflicts is one thing that we need to be concerned about. The other things emanating from this demand-and-supply imbalance are increases in prices and also in price volatility. Finally, an under-discussed concern is the real risk of resource nationalization in a world where commodities have become scarcer.
What form would resource nationalization take?
It could be a whole range. In Australia, they’ve increased the tax on mining and iron companies by over 30%. Nationalization could also be much more aggressive, as with expropriation, which you’ve seen in places like Argentina and Venezuela, where the government just takes full ownership of some assets. The discussion around natural-resource nationalization has become a big deal, everywhere from Mongolia to South Africa.
How do you see price volatility extrapolating in the future?
Weather concerns, political volatility, and political actions also exacerbate commodity price pressure, but I think the real driver is going to be the structural fundamental demand-and-supply challenges that I’ve already outlined.
If you look at the IMF forecast or the forecast from the U.S. Energy Information Administration [EIA], you can see that this concern about commodity price increases (and therefore the impact on our living standards) is very real. Both these agencies forecast, for example, that oil prices could be as high as US$200 dollars a barrel over the next decade.
What else would you want investors to know about the frontier?
Mainly two things. In terms of equities we’re talking about more than US$1 trillion in market cap, with 8,000 stocks that trade in that frontier market space. About US$200 billion of it is a free float, and I really believe that in terms of diversification, there is a real story for investors going back to basics of picking stocks based on micro fundamentals instead of this whole risk-on/risk-off phase, which is what we’ve been in for the past three years.
The fixed-income side is another place of real opportunity. Take Africa, for example. Today we’ve got almost 20 countries that have credit ratings. Just in the past eight months, we have seen at least four countries come to the market—Tanzania, Angola, Zambia, and Morocco. They’ve done big bond issues in the market, ranging from US$600 to US$750 million. We’re talking about bond issues that were 10 or 15 times oversubscribed in some cases and very aggressively priced. They are pricing more aggressively than Spain, Portugal, or Italy. So it is a real solid story. These countries now have credit ratings, which they are using to
issue debts, and the market loves that.
For people who are interested in opportunities for alpha generation, who want to get off their benchmark hugging, I think these markets are ignored at their own peril.
Jonathan Barnes is a financial journalist in the San Francisco Bay area
The techniques for doing business in emerging markets that Dr Moyo mentions early on in the article are the traditional Chinese ways of doing business so there is some comfort level for them in Africa, especially.
The danger of commodity based conflicts might merit a whole new thread, if one doesn't already exist.
op:
