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By Channa Fernandopulle
Fiscally conservative emerging market nations with reformist agendas are most likely to continue drawing Foreign Direct Investment (FDI) as economic recovery in the West pulls some liquidity back into developed markets.
Speaking exclusively to the Daily FT during a brief visit to Sri Lanka, IFC Research Head Jean Pierre Lacombe projected that emerging markets would face greater competition for FDI over the short-medium term as investors become more selective about which countries and sectors they enter in the backdrop of challenging macroeconomic conditions which negatively affect returns on equity in emerging markets.
“Looking at emerging markets we see that earnings per share, profit margins and return on equity are all dropping. Investors have been paying attention to this and are gradually taking money off the table from riskier countries and re-investing in countries which exhibit stronger macroeconomic management and have embarked in substantial reforms like China, India and Mexico, for example.
“We created an index with reformer countries – China, India, Indonesia, Mexico and Colombia – and compared it against emerging market countries which are not reform minded and we found that the reform index delivered excess returns of 20-25% since early 2014. This is a very meaningful difference and the trend carries over to countries that have less macroeconomic vulnerabilities,” he noted.
In terms of the implications of emerging market trends for Sri Lanka, Lacombe was careful to qualify that he was not an expert on Sri Lanka, but nevertheless spelled out general improvements that could be made to make Sri Lanka a more attractive investment destination.
Among his suggestions were steps to diversify the island’s export base, particularly given anticipated deflated commodity prices. In that context, Lacombe praised efforts to move the country’s apparel industry up the value chain.
He further suggested that improvements be made to the legal, regulatory and doing business environment while increasing female participation, creating an educated workforce and implementing energy pricing that could result in a more competitive manufacturing base.
“Increasing female participation was one of the big sources of growth for Latin America, it increased the amount of people working, which meant more people earning and paying taxes. Increasing skills is also crucial. I’m told you have 500,000 tuktuks in this country but you cannot increase the productivity or earning power of the people operating them, they would not contribute to expanding growth. It is crucial to enhance vocational education that puts people on a higher trajectory,” Lacombe noted.
Charting the course of emerging market fortunes following the global financial crisis, Lacombe explained how policies of quantitative easing had created massive liquidity. Investors left with few attractive investment options in the developed world looked at emerging markets given the favourable macroeconomic variables as well as powerful demographic and income trends. Emerging market assets offered more potential return and a positive story.
Higher flows ensued creating a boom in private credit that fuelled consumption rather than investment (except for countries like China) that ensured robust growth and higher productivity. The virtuous cycle which saw a large accumulation of FX reserves, an expanding monetary base, a boom in private credit and consumption has slowed down substantially.
Lacombe cited consensus forecast growth expectations for most large emerging economies like Brazil, Russia, China, Turkey and South Africa – all of which showed sharp downward revisions since 2013. He noted that the pace of growth could be sluggish going forward.
Lacombe further noted that continued economic recovery in the United States would lead to a continuation of the dollar bull-run in the short term. Noting that consumption levels in the United States had not shown significant improvement of the last year despite a sizeable increase in income, Lacombe nevertheless expressed confidence that consumption would pick up in the second half of 2015; a fact which could bode well for Sri Lankan apparel exporters.
However, returning to the issue of lower liquidity in emerging markets, Lacombe cautioned that a stronger dollar and reduced dollar liquidity outside of the US (courtesy of a lower current account balance) would create a difficult operating environment for companies that have significant amounts of debt.
“The large growth of dollar debt outside the United States is something that worries me as liquidity is going down at the same time that the cost of debt is going. If this trend continues, it would be advisable to avoid companies that are heavily leveraged in US dollar terms,” Lacombe said.
He added that the impact of lower FDIs and smaller portfolio flows may affect East Asian countries but to a lesser extent nations like Sri Lanka that are less linked to the United States.
Commenting on the Chinese economic position, Lacombe expressed continued sluggishness of Chinese growth in light of softer global trade and the continued effect of reforms in the country.
“In the past there were people who expected China to maintain a very high 8-9% real rate of growth, but we remained sceptical as the world was slowing down. Lower rates of growth for China between 6.5% and 7% are lower than in the recent past but will not affect China significantly.
“However, countries and industrial sectors that anticipated high China growth, that leveraged and increased capex based on these expectation are and will continue to suffer. Slower Chinese growth means that demand for metal and other commodities will continue to go down,” he explained.
Lacombe went on to project that a Chinese economy growing more slowly would result in soft commodity prices for the next year, given that Chinese demand accounts for approximately 50% of total demand for most industrial commodities.
“The pace of demand for metals is definitely going down and that will have ripple effects for producers in emerging markets. Some countries that are mostly importers of energy and food are going to be winners and net exporters are going to experience large revenue falls, especially those countries like Nigeria where a single commodity like crude oil accounts for the majority of Government revenue,” he said.
