With the slowing of the emerging market economies it is possible that 2013 default rate could achieve a new record. As the business cycle moves into an inevitable contraction, one success of the central banks may result in a dismal failure

It wasn’t supposed to be this way. Emerging markets, especially the BRICS countries, were reputed to grow far faster than developed countries. Investments in emerging equities markets were a one way bet. With expanding young populations, cheap labour and growing consumer demand, emerging markets were supposed to routinely turn in annual GDP (gross domestic product) growth of over 5%. It has not happened. The US S&P 500 has witnessed record highs and an impressive 11% return in the first quarter, while emerging markets have had generally disappointing results. Europe, perennially on the verge of crises, managed a 12% rise. The Japanese market, often written off, has achieved an astonishing 28% return.

In contrast many emerging markets have lost ground this year. The worst is Brazil, which is off 7.8%. India is next, where the BSE has dropped 3%. Russia is off 2.6%. The Chinese market appeared to be showing signs of life, after a 20% rise from December lows—it has again experienced an 8% decline and is off 1.66% for the year. As a whole, emerging market stocks have experienced their biggest first quarter drop since 2008. In theory, emerging markets should attract buyers because of their valuations which are 11 times 12-month projected earnings, compared with 14 for the MSCI World Index.

In a way it is a bit unfair. The boom in developed country markets is primarily based on a flood of free money. Emerging stock prices don’t jump upon the happy pronouncement of ever more easing by American or Japanese central bankers. On the contrary. The Chinese government has made it clear that rising inflation at 3.2% is too high. But their problem is far less than other emerging markets. Russia, Brazil, Turkey and South Africa all are coping with inflation rates above 6%, while India’s inflation rate has remained stubbornly above 8% for over a year.

In fact without the illusion provided by monetary policy, the emerging markets may more accurately reflect the reality of the world economy. After four years of expansion, it is rather late in the business cycle. Global growth forecasts are being cut from 3.3% to 3.1% and emerging market forecasts declined from 5.5% to 5.3%.
 

Brazil is particularly troubled. For many years it appeared to be on the path of sustainable growth. Between 2004 and 2008 it averaged an annual growth rate of almost 5%. Now that growth has declined. The average growth between 2011 and 2012 was only 1.8% less than the growth of the United States. Falls in commodity prices and lower exports to China and Europe haven’t helped, but the real problem has been a fall in labour productivity, various bottlenecks like inadequate infrastructure, a bureaucracy with an insatiable taste for red tape and weak investment.

The economy of Poland was one of the few economies in Europe that never experienced a recession. But its proximity has limited its immunity to the problems of the Eurozone. When the numbers out of Europe and especially Germany, Poland’s primary market, fall, Poland’s statistics follow suit. Its unemployment rate increased to a six-year high of 14.4% and increased from 14.2% in January. Retail sales have fallen by 0.8% and the forecasts of GDP growth of 1.5% look out of the question.

Another country that has been affected by Eurozone issues is Turkey. A recent economic tiger with growth of more than 8% in 2010 and 2011, it has shrunk to more of a house cat with growth last year of 2.2% slowing to 1.4% in the fourth quarter. The year-end bounce that was supposed to have been stimulated by monetary easing never materialized. Exports have slowed. Foreign direct investment has cooled from over $40 billion to $8 billion.
 

Falling oil prices due to falling demand has impacted Russia. The numbers for February showed a miniscule amount of growth at 0.1% down sharply from the 1.6% growth recorded in January, but consistent with the trend. The Russian economy has been slowing for five consecutive quarters.

The tables have been turned on what was to become the S in BRICS. South Africa used to make up 40% of the total GDP of the 48 countries in Africa south of the Sahara. Its closest rival was Nigeria in second place at 14%. Today, while the South African economy can only manage 2% growth, the rest of Africa’s average rate has risen to 6%. Peripheral Europe is not the only place to experience a downgrade of its sovereign debt. The rating agencies have not only downgraded the South African sovereign credit rating, but also five major metropolitan areas and two state-owned companies.

China’s government reversed its tightening last year, just in time for the leadership change in October. The reversal allowed a revival of the real estate boom. Both housing prices and inflation began to rise helped by an explosion in lending through the shadow banking system. With the worries over a political hand off out of the way, the Chinese government is again trying to slow out of control financial and real estate markets. New regulations limiting the sale of Wealth Management Products have been created. Taxes of up to 20% on sales of houses are supposed to come into effect along with real estate taxes which have previously been unknown.

The general assumption is that emerging market problems are due to issues in the developed world—slow growth in the US and a recession in Europe. The reality is that emerging markets have been slowing for quite some time. If you look at the GDP growth charts for China, India, Brazil and Turkey they all reveal the same thing. They all recovered very rapidly from deep downturns in 2009. Their growth sprung back quickly and hit highs in early 2010. But then the increase in growth rates stopped. The trend in growth has been downward ever since. Until today when in many emerging markets there is barely any growth at all, certainly not the advertised vibrant growth of 5% or more.

The promise of their markets has also been an illusion. While the US equity markets have made a slow but steady progress from March 2009 to their recent new highs, many emerging markets have moved in a trading range. Russia, India and Brazil reached post crash highs in 2010 and have not moved any higher. The Chinese market peaked in 2009 and has been on a slow but steady decline ever since. The exceptions are Indonesia and Turkey whose markets have progressed upward over the entire four years.
 

 Russia

Turkey

Unlike their stock markets, emerging market bonds have done well. Much of the capital flows into emerging markets have been due to the largesse of developed countries’ central banks. The suppression of interest rates has stimulated an international hunt for yield and a higher tolerance for risk. However, the steady decline of emerging markets does not bode well. Much of the demand in the world economy and the source of record corporate earnings came from emerging markets. As they begin to contract, we will see the effects.

Already the default rate from emerging market corporate issuers has begun to rise. Emerging market corporations defaulted on $22 billion of their obligations last year, a massive jump from the $182m of defaults recorded in 2011. In percentage terms, this translates into an emerging market corporate default rate of 1.43% in 2012, compared to 0.33% in 2011. The problem was especially acute for junk bonds. Last year was the fourth worst year on record for junk bond defaults in emerging markets. One would think that 2009 took the prize, but that is not true. Defaults in emerging markets were especially bad in—1998, 1999 and 2001—and years of the Asian financial crisis, the sovereign crisis in Russia and the 2001 default of Argentina respectively. With the slowing of the emerging market economies it is possible that 2013 default rate could achieve a new record.

Central bankers have shown themselves particularly adept at inflating certain asset markets. They have not been as successful in creating real growth. As the business cycle moves into an inevitable contraction, their one success may result in a dismal failure.

(William Gamble is president of Emerging Market Strategies. An international lawyer and economist, he developed his theories beginning with his first hand experience and business dealings in the Russia starting in 1993. Mr Gamble holds two graduate law degrees. He was educated at Institute D'Etudes Politique, Trinity College, University of Miami School of Law, and University of Virginia Darden Graduate School of Business Administration. He was a member of the bar in three states, over four different federal courts and has spoken four languages.)