Only a little shiver ran round the emerging markets after Thailand’s imposition, then partial removal, of capital controls last week.

No risk pricing

But the chill should be salutary. For the strongest trend in emerging markets in 2006 has been investors’ continued willingness to ignore potential risks. After Thailand’s policy flip-flop, spreads on emerging market debt, according to JPMorgan’s EMBI+ index, widened a mere 2 basis points to 179bp over US Treasuries. Equities, measured by the MSCI Emerging Markets Free index, fell 2 per cent but then closed on Thursday near to record highs, having risen 26 per cent so far this year.

Investors have some reason to be relaxed. The majority of emerging markets are enjoying strong economic growth. The commodities boom has helped countries as diverse as Russia, Mexico and Indonesia to reduce debt, improve external trade positions and strengthen national balance sheets. Among the bigger markets, only Turkey, Brazil and India have general government gross debt of more than 60 per cent of gross domestic product. Next year, owing to debt buy-backs and refinancings, as well as economic expansion, the ratio of emerging debt to GDP should continue to fall.

These fundamental improvements mean that the emerging markets are better placed than at any time in the past to deal with a global growth slowdown or other external shock. A modest decline in commodity prices is unlikely to undo the progress made in creditworthiness. Sharper corrections would be more difficult to handle. Some economies have not been able to reduce their vulnerability – South Africa, Turkey and Hungary, for example, are running substantial current account deficits. Asia is particularly exposed to any slowdown in global growth and, thus, in demand for emerging market exports: average exports of goods and services exceed 50 per cent of GDP.

Inevitably, stock market indices have become increasingly dominated by commodities-related companies. Credit Suisse estimates that the energy and materials sectors account for 41 per cent of this year’s emerging market earnings. Some markets are even more unbalanced – in Brazil the metals, mining, oil and gas sectors make up nearly half of market capitalisation while hydrocarbons and other commodities are more than four-fifths of Russia’s.

Flickers of concern are reflected in earnings forecasts and equity valuations. The MSCI EMF is trading at about 12 times forward earnings. This is lower than before the Asian crisis of 1997-8 and during the dotcom boom. But the discount to the MSCI World index has narrowed to 15 per cent compared with 45 per cent at the bottom of the economic cycle.

Such numbers do not suggest emerging market assets are wildly expensive. The liquidity environment certainly remains supportive. Despite a blip in May and June during the global equity sell-off, a recent surge of new money has taken net inflows into emerging market equity funds to a record high, according to Emerging Portfolio Fund Research. In the year to December 13, inflows totalled $21bn, surpassing last year’s record $20.3bn, while inflows to emerging market bond funds, at more than $6bn, also exceeded 2005 levels.

Other global trends are also helpful. Private equity will deploy the huge amount of capital it has raised in many different places. Blackstone Group, for example, which runs the world’s biggest buy-out fund, and Citigroup’s private equity arm, are in discussions with India’s government about investing $5bn in infrastructure projects. The beneficial side-effects of this kind of initiative on publicly listed companies in developing countries could be enormous.

The worry, of course, is that, as in developed markets, both private and public emerging markets investors are becoming less and less fastidious in their choices. Some of the improvement in balance sheets and external positions look permanent. But the lesson from Thailand is that it is still important to be picky.

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