Taking advantage of Emerging Markets turmoil

Let’s focus on the positives. The current turmoil in Emerging markets is not all bad. It is also throwing up some good opportunities for investors. Let us discuss a top down approach to shortlisting EM countries.

A few of my observations about EM economies in last few years are summarized in table below. The table suggests which emerging markets will do well in different scenarios of economic growth (rows) and monetary policy (columns) in developed markets (DM).

	Easy DM monetary policy	Tight  DM monetary policy
DM economic growth high	All EM	Export oriented
DM economic growth low	Domestic demand	No one rule applies

When developed markets have high growth rate, export oriented emerging market countries benefit the most and grow fast. In the flip scenario exporting countries are hurt the most. When DM central banks are going around dropping money from helicopters, their monetary policy also influences EM growth. In times of easy monetary policy, money flows in to all EM countries, and all see outflow in times of tight policy. The amount of money making these rounds is determined by prevailing DM growth rates.

• The first filter for shortlisting countries comes from this table, depending on our expectation of events in developed markets.
• My views of what makes a country structurally strong determine additional filtering criteria. One is economic driver for EM countries – whether it is domestic consumption, fixed investments or exports. I believe that for long term, EM growth should be driven by exports or fixed investments and slowly transition to domestic demand. A country dependent on domestic consumption for growth should have a high GDP per capita or sustainable income source to fund the consumption. In absence of that, it is risky to invest in such an EM country.
• Then, choose a country which knows what its core competence is, and sticks with it. Such a country will be competitive in its area of strength. Even in an unfavorable economic environment, it can afford to sit out and wait, assuming that domestic finances are managed well. A country which tries to change its economic drivers needs more careful assessment. Iceland is a good case study. The country was mostly engaged in fishing and related industries before its rapid growth and subsequent crisis in 2008. Now it is moving back to its original business and economy is stable. I bias in favor of such countries.
• Another important point to consider is quality of management of economy and country. Credibility of policy is important. Its continuity over political cycles is pure gold. A country with such characteristics will be a good place to invest money irrespective of its short term growth trends.
• Lastly, I also look at social situation in countries. Mass protests for apolitical reasons are sign of popular pain. This may be due to economic, political or social reasons, or a combination of these. Presence of such movements suggests caution in investing in such countries, especially in times of slow global growth.

Using all these filters, some undoubtedly involving qualitative judgment, we will arrive at a short list of EM countries which are potentially good places to invest in.

Inheritance and Growth

An interesting article in FT – ‘Inheritance should not be an alternative to hard work’ talks of rising importance of inherited wealth, on a scale that will make it a viable alternative to work. This is a result of slow economic growth in rich countries. Slow growth reduces wealth created by other sources and hence increases importance of inheritance.

The phenomenon is noteworthy for its social, political and economic implications. If it persists over long term, it would influence direction of economies, their efficiencies & sustainability. It would also present risk to belief in fairness of society. The issue, and all its effects gain importance in an environment of slow growth over a long time horizon.

One solution to this issue is higher economic growth. However, the structure of this growth is important. To be sustainable, growth should be based on productive activities, i.e. those that produce goods or services of some utility, and not just an asset price increase. Another attribute of sustainable growth is perception of fairness of opportunity, i.e. a perception that everyone gets an opportunity to benefit from the growth. The existing economic structure should also have an element of meritocracy, a belief that at least to some extent people have a control over their destiny. When inherited money becomes more important, perceptions of fairness and meritocracy become weak.

These factors are useful benchmarks to evaluate government stimulus programs in different economies. Measured this way, most governments today need to do more to ensure sustainability of growth. Scrambling for growth in any form is not the way to do that.

Reference: http://www.ft.com/intl/cms/s/2/d8b97920-76eb-11e3-807e-00144feabdc0.html#axzz2qETu7tZb

Bits and coins

Bitcoins – a new way to get rich! They are going up! up! up! Excitement is spreading. Tiny island of Alderney wants to become the first jurisdiction to mint Bitcoins in partnership with UK’s Royal Mint (FT article¹). It seems Bitcoins are going mainstream now.  Is it all for real?

I am not so sure. I think it is a bubbling bubble. As Greenspan remarked (Sydney Morning Herald article²), there is no intrinsic value to the currency or credit of the issuing entity backing it. Then holding a Bitcoin does not give a right of being paid any money by anyone.  In a recent report³ Citibank raises the issue of competition from other virtual currencies also.

However, the brand seems to have a deeper appeal to the faithful. Its anti-establishment nature is one. Ability to go around government restrictions is another. A South China Morning Post story⁴ talks of Bitcoin popularity in China, partly for its ability to avoid capital controls. It also makes transactions more convenient and cheaper in the new e-conomy. A story in The Hindu⁵ talks about small tea gardens in India exploring Bitcoins usage to lower transaction fees.

So what do regulators think? Governments don’t like things they can’t control. They have some genuine concerns too. Ease of money laundering and illicit fund flow is one. Regulators might also worry about virtual currencies creating an alternate financial system in extreme scenario, thereby increasing financial volatility. On Friday, People’s bank of China (PBoC) banned financial institutions from dealing in Bitcoins (Bloomberg⁶). Thailand has already declared Bitcoins illegal. However, most regulators are as yet undecided.

A likely future scenario is of regulations gradually increasing around Bitcoin usage. However, virtual currencies won’t go away until & unless alternative arrangements evolve to fill the voids that they fill today.

References:

1. ‘Alderney looks to cash in on virtual Bitcoins with Royal Mint reality’ – Financial Times
2. ‘Bitcoin a bubble, not a currency says former Fed chief Alan Greenspan’- The Sydney Morning Herald
3. ‘More on Bitcoin as a currency’ – Citi research
4. ‘Chinese Yuan dominates global Bitcoin trade’- South China Morning Post
5. ‘Tea growers explore Bitcoin option to expand global biz’ – The Hindu
6. ‘China bans financial companies from Bitcoin transactions’- Bloomberg

Popular discontent in Brazil

A recent article about middle class protests in Brazil had some interesting explanations for the events, which I’d like to share. The analysis cited three main reasons for the protests.

First, infrastructure improvement didn’t keep pace with improvement in people’s homes & offices i.e. growth rate of people’s income exceeded growth rate of economy. This caused discontentment in middle class.

A high growth rate of purchasing power implies fast income growth and/or higher credit availability. Then there are two ways discontent can grow. One, when economic conditions stop improving. This can be via stagnation in wages, or reduction in credit availability. Discontent can also brew if rate of improvement of economic conditions is not sufficient i.e. growth rate of economic conditions could be positive, but slower than negative forces, so that overall situation deteriorates. E.g. wage growth rate could be positive but still lower than consumer or asset price inflation. So the situation is effectively contraction in income. A salient feature of US style capitalism is an increase in inequality. A few people benefit from asset price inflation, while majority pays the price. This produces a sense of injustice, thereby exacerbating discontent.

Second, income of boom years was consumed and not invested. So a lot of improvement in people’s condition was short term and didn’t carry through in lean period. People also borrow more to keep the party going as long as possible, which means that when the party ends, not only do wages get pressured, debt burden hurts too.

Third, related to previous two, is consumerism, wanting to consume more and more. People got everything they want easily (via credit) and not being able to do that any longer made them angry.

It is interesting to note significant role of credit in this story. Looked one way, credit provides an ability to consume more than one can afford. Governments of major countries are promoting the same with easy money. However, we already know how this movie ends. If we compare the response of governments with what an individual would do, most countries do not fare very well:

		US	EU	JP	CN
1	Increase income (Create production capacity)	X	X		√
2	Control costs	X	√	X	X
3	Save money	X	X	X	X
4	Reduce debt	X	√	X	X
	Else
5	Get more debt	√	√	√

Wage Story

Last Monday morning I was sitting at airport, seeing off my better half, when I chanced upon a small advertisement for a shoe shine service. Like everything else at airports this also seemed a bit overpriced. My thoughts moved to broader topic of high minimum wages in certain countries. Are they beneficial for economies or harmful? Do high wages impede economic growth?

 

One can argue from both sides. Disadvantages of high wages include reduced efficiency in the system, higher manpower cost for companies and higher hurdle rate for starting new companies. Thus higher wages can impede job growth. However, on the positive side, higher wages promote more equitable distribution of wealth. By putting more money in pocket of poor they help increase domestic consumption (since poor spend a greater proportion of their income than the rich).

 

Okay, so what are the conditions where higher wage system is more appropriate? If a country has higher wages, then companies will need to charge more to offset manpower costs. So prices will be higher (Price levels only. Inflation may or may not be high). A rich society will be able to afford these elevated prices, poorer society will find cheaper alternatives (informal economy). Additionally, in most cases the society with high price levels would need to have relatively low population growth rates. This is because high wages would lead to relatively slower rate of job creation. (This assumes that the economy is not dominated by fast growing high value add industries). Then, one can conclude that high minimum wages are more appropriate for developed economies (high GDP per capita, high PPP, slow population growth), while low wage system is more appropriate for developing economies (low GDP per capita, faster population growth, need for more job creation).

 

A high wage system, however, is more difficult to maintain in recessions and slow growth periods. High price levels imply more difficulty for poor to survive. Thus a need for government support programs like social security, unemployment benefits etc. However, if this support is removed or reduced then it’ll have direct implications for society in magnitude (roughly) proportional to number of unemployed. Variants of results are visible in developed economies all over – political tilt towards socialism (US), increase in support for extremist parties (Netherlands, France), breakdown in social order (Greece), and governments avoiding reforms (taking short term measures to solve long term problems) to appease masses (France).

 

Efforts to counter this via money printing can have only limited success. In fact, certain amount of deflation would help, by bringing prices down to affordable levels. Of course, economic activity would still need to accelerate to avoid a downward spiral.

Mexican Puzzle

Prostitution doesn't pay in Mexico

Mexico's prostitutes must be very poor. Dear reader, if you were to have some spare time and decided to leisurely skim through Mexico's national accounts tables, you will also come across a table 'Household consumption and private non-profit, total spending on the domestic market', classified by purpose showing household spending categories. In this table, within the section 'Total miscellaneous goods and services', is a sub-heading - 'Prostitution'. Obviously it must be a fairly important industry in there. However, the recorded expenditure in this category for last few years has consistently been zero. Does that mean that Mexico's prostitutes are the most underpaid in work and they do their job just for the love of God? The reality is probably that prostitution is big business but mostly in informal sector. Thus a big expenditure category with zero official expenditure.

Japan: back to past

Japan finally decided to raise sales tax from 5% to 8%, effective Apr2014, with some offsetting stimulus measures, mainly in form of corporate tax reduction. With this, the government has taken firm steps towards the familiar low growth levels. 

Japanese consumers are already suffering from supply side inflation. Closure of nuclear power plants and fall in yen are leading to higher import price inflation, and thus higher domestic inflation. Higher sales tax on top of that will hurt domestic consumption strongly. 

The government hopes to increase Japanese household income to counter this problem. So they are asking the industry whether they can do something about it. The government also has a goodie bag of its own which includes tax exemptions for new house purchases and for equity investments. The problem is that these measures are not sustainable. In a land of shrinking population housing demand can be stimulated only so far. When that population is ageing, it saves a lot and that also in safe options like bank deposits and government bonds. Hoping to move them to equity markets is rather ambitious. 

What Japan really needs is structural reforms. That is a very difficult and potentially unpopular task, especially in a traditional society. That is also the topic of Mr. Abe’s third arrow which seems to have gone missing.