Saturday, March 29, 2014
Why do EM bear markets happen?
A proper economist should probably look over this and clean it up so that it makes sense. Maybe it doesn't even.
But I just came up with an interesting attempt to explain to myself (and someone in the comments section) the emerging market bull/bear cycle. Note of course I'm not an economist, I work in engineering.
So you should take this post as simply one guy trying to comprehend economics on his own.
Anyway, the question was: why can't EMs exploit a DM secular bull market? I was saying the answer is the cost of money and the change in flows, because I've read that smart people say this. But I never really tried to puzzle out why that would be.
OK, here goes:
In a secular DM equity bear, there's still DM capital out there that wants a return, but it's not going into DM equities for whatever reason. (I guess the most recent US secular bear was because the equities market got so horribly overpriced in 2000 relative to expected earnings that eventually it had to fall into a long period of consolidation.) Expectations of future return in that DM's equity market go down, so capital needs to go somewhere else to turn a profit.
So at least some of that capital starts going into EM debt. It has a high return because the risk premium is nuts - and should be nuts, since you've got revolutions and coups and always a high possibility of default if a country decides to follow a political path that makes it uninvestable (like Cuba or Venezuela in the past, or Russia presently).
But there's more DM capital than there is EM debt, so the interest charged on EM debt goes down. Market value of EM bonds goes up and that new bull market sucks in more and more DM capital, because investors always chase past returns.
Hey look! All of a sudden that EM can issue more debt at a cheaper price, and build out some infrastructure and invest some money in skills training! Suddenly they have the capital they needed to grow their economy!
And eventually EM debt interest goes down so low that its price becomes stupid. E.g. Mongolian 2022 Chinggiz bonds once yielded under 6% - and this is a country that tried to confiscate Oyu Tolgoi.
And here's where my clever idea comes in:
The problem is that as DM capital floods an EM, a massive portion of the money will get wasted in corruption. Basically, it produces no return in the economy - it gets nicked by politicians and stocked up in gold bars in numbered Swiss accounts. We've already seen this in China, where their big stimulus program created an army of Chinese millionaire politicians.
Eventually, the tide turns. DM capital sees the beginning of a new secular bull in the DMs, and realizes it's dumb to stick around with a 5-6% return on bonds in a shitty EM (with all the possible capital loss downside) when capital can just invest in the US equities and earn 6-8%/yr plus dividends.
So at that point you see EM-DM capital outflows, EM debt interest skyrockets, and without access to more credit they can no longer build their economies.
But why can't the EMs still grow at 10% in a secular DM bull market? I mean, come off it! If the US GDP was growing at 4-5% a year instead of 1-2%, that certainly should provide an export opportunity for EMs to exploit, no? Why doesn't DM capital stick around at a higher interest rate?
Well, there are some guys out there saying that part of a DM secular bull involves increasing per capita productivity. So the US will see its productivity improve tremendously over the next few years because of cheap prices for power due to that shale natgas thing. Others point out that new technologies (computers, automation, etc.) can get exploited by US companies that essentially improve per capita productivity.
But why can't the EMs also access those advantages?
Because #1, they have (relative to the US) no domestic capital in their own economy. They need foreign flows to pay for investment because they don't have their own money to invest with.
And #2, here's the money shot: the economic return on capital in an EM is always going to be lower than the economic return on capital in a DM because in the EM, a large portion of that capital is siphoned off by corruption instead of providing a return to the economy.
So an EM's economic return on capital is lower, and yet the interest demanded by capital is higher due to the higher risk premium on EM debt.
So for every dollar of investment capital, an EM has to pay more interest and get less of a return. Basically they will always have a disadvantage in cost of capital and a disadvantage in return on capital.
OK, let that sink in first.
OK, now think about that last statement and its relation to the question at the start, and you'll see I just sandbagged myself.
So how can EMs ever compete with DMs, if they have these disadvantages? How do EM secular bull markets happen?
Well, I guess EM growth is generated by the size of capital inflow, more than the return on that capital.
For growth, an EM will need, relative to its GDP, more money than a DM needs. E.g., if India wasn't run by upper-caste kleptocrats, then if someone loaned them a few trillion dollars they could spend that trillion on upgrading skills to make everyone in that country as well educated as their cousins are here in Canada. And maybe some modern bathrooms to address that whole plagues-of-cholera thing.
We in Canada don't have that capital demand because we're already as well educated as Canada. And have bathrooms.
Basically the infrastructure, production and skills deficits in EMs are higher, so they have a higher demand for capital per capita to spend on reducing those deficits, but they have a lower level of domestic capital (i.e. wealth) per capita (because there are still so many poors - and because their rich invest in the DMs, not so much in the EMs). So when a big glob of foreign capital rolls into an EM, from the single richest country and largest economy in the world, then it doesn't matter what the interest rate is or what % return they get on each dollar - the aggregate size of the inflow adds to that EM's economic growth.
But when that money flows back out, it's no longer around in that EM, and suddenly they don't have the money to invest in GDP growth.
Looking at this, I'm pretty sure you would read it all in a second-year economics textbook.
But you don't. Because you're reading this blog instead of getting a proper education.