Question of maturity in developing economies

Whatever the case for investing in emerging markets, it appears to have convinced many investors.

Flows into both equities and debt of emerging markets are running at a record rate. They even reached the point this week when Brazil, one big emerging market, felt obliged to respond by introducing a direct 2 per cent tax on investment inflows. It felt the appreciation this was causing for its currency was damaging exporters.

Colombia had already taken steps to limit its own currency. Speculation surged that countries from South Korea to South Africa would do the same.

Meanwhile, the economic data for the emerging markets seemed to justify the enthusiasm. China’s gross domestic product grew at 8.9 per cent in the year to the third quarter, according to the latest official data. The GDP of the UK, one of the bigger developed markets, shrank over the same period.

So far this year, investors in these markets have been repaid amply. The extra “spread” in yield that emerging market government bonds pay compared with US Treasuries is down from 8.65 percentage points during the crisis last October to less than three percentage points now, JPMorgan says.

As for equities, the FTSE’s emerging markets index has more than doubled in the past year even if it remains almost 25 per cent below its pre-crisis peak.

What are the reasons for this and are those reasons valid for the future?

Among traditional arguments are that emerging markets are cheap and provide returns that are not correlated to returns elsewhere in the world. This is often referred to as the “decoupling” argument – that the bigger emerging markets can now grow even if the developed world is in recession.

Emerging markets used to be cheaper than the developed world because they were believed to carry more risk. They lived up to this throughout the 1990s as crises swept through the emerging markets.

The MSCI Bric index (covering Brazil, Russia, India and China) has been back-tested to 1994. Remarkably, it was no higher 10 years later than at this inception, and only consistently overtook the performance of the MSCI’s developed world index in 2007. Since 2002, however, the Bric index has outperformed by 273 per cent. That is mainly because they started out too cheap.

But if we look at multiples of book value (the value of a company’s assets minus its liabilities), emerging markets, at a multiple of 2.1, are now more expensive than the developed world, at a multiple of 1.75, according to the MSCI figures.

As for economic decoupling, research by Eduardo Levy-Yeyati of Barclays Capital shows that emerging economic growth is even more closely correlated to the growth of the developed Group of Seven countries in this decade than it was in the past – if China is excluded from the data.

Once China is included, then the G7 is indeed much less important in predicting emerging economic growth, but only because China now becomes all-important. This confirms the popular conception of China as a rising new economic pole for the world. Rather than being coupled to the traditional powers, the emerging markets seem to be coupled to China.

As for markets, the trend continues to be that emerging markets benefit in spades from any news that is good for the developed world. As the chart shows, emerging markets outperform the developed world when the developed world is doing well and underperform it when the developed is doing badly – the precise opposite of decoupling.

Relative to the developed world, emerging markets are even stronger than they were at the top of the market before the crisis.

There is a partial exception to this. Last October, emerging markets hit a ledge and began to recover several months before the developed world hit bottom.

That in turn was because what appeared to be a classic emerging markets crisis – with currencies falling and companies defaulting as investors pulled money out – arrested itself before the economic damage became critical.

That is certainly very good evidence that emerging markets are a better bet than they used to be. The larger markets had taken steps to improve their fiscal and monetary stability and reduce their reliance on debt denominated in foreign currencies, and thus resisted the forces pushing markets downward.

But this also puts the move by Brazil and others to limit capital inflows into perspective. The authorities in the emerging world showed last year that they were in control of events and could survive a crisis. And they are uncomfortable about the hot money coming in.

It looks as though the emerging markets have matured, but the investors putting money into them have not. This is a cause for concern.

john.authers@ft.com