Friday Letter: Emerging risks

As developed markets move back into growth, emerging ones look likeliest to play host to the next financial crisis. Are investors right to shy away?

Emerging markets have had a tough time of it, even without the glare of global scrutiny the World Cup has shone on Brazil. But as developed markets – and in particular the US and Northern Europe – emerge from the downturn, a financial crisis in emerging markets remains one of the most significant risk factors for investors everywhere.  

Such markets are typically characterised by high levels of growth. Much of that has been fuelled by borrowing, and yet the recent slowdown in GDP growth, together with international regulatory reforms designed to curb the riskiest of lending practices, have meant many SMEs in those countries have been starved of credit – certainly from overseas sources.  

It’s one reason that Chinese regulators have been working hard to increase liquidity to SMEs and MSEs (small / micro enterprises). The China Banking Regulatory Commission recently amended bank loan / deposit ratios in a bid to spur lending to such companies, although ratings agency Fitch pointed out that such companies typically represent much higher credit risk than larger corporates. Thus such a move by the regulator has the potential to negatively impact the credit profile of the country’s banking sector.  

“There are also risks should loans to MSEs be re-routed into property or other speculative investments such as shadow banking products, which would undermine the government's objectives to reduce funding to these areas,” Fitch said. 

At a breakfast briefing held by ING Investment Management earlier this week, the Dutch group’s head of multi-asset management, Valentijn van Nieuwenhuijzen, argued that emerging markets like China represent the greatest threat to global financial stability.  

Although the country’s growth seems to have stabilised – driven by better export growth to developed markets and some modest policy stimulus, the correction in its real estate sector has been damaging, he argued. Expansion of its credit sector continues to be much faster than its nominal GDP growth, he added.  

Rising inequality and social unrest, particularly acute in markets like China or Brazil, as the demonstrations ahead of the World Cup have demonstrated, remain a potential spark that could ignite at any time and foment a genuine crisis.  

Turn to Eastern Europe, and you have the ongoing strife in Ukraine as evidence that the region remains an unstable one.  

China, however, is arguably better placed than its EM peers to address a financial crisis. Its banks are already nationalised, so it’s much easier for the Chinese government to manage a developing financial crisis than in, say, the US or UK. A crisis with China at the epicentre will be a very different one, if it occurs, than the previous global financial downturn.  

China also has a thriving non-bank lending community too, however. For investors in private debt, emerging markets undoubtedly represent a riskier play than developed ones. When the attraction of private debt is the risk-adjusted returns on offer, it is perhaps understandable that many investors would shy away from markets which have the capacity to skew that metric too far into ‘risk’ territory. But some managers have made a real success of sourcing private debt opportunities in such markets, and with the right controls and risk mitigation strategies in place, the rewards are there to be had. And in turning a profit, funds can also help to make a real difference to local economies, delivering much-needed liquidity to SMEs.  

As van Nieuwenhuijzen said at the briefing, “Achieving growth as a means to address social inequality, the overleveraging of the banking sector worldwide, and other pressing issues is so much more important than crying wolf over bubbles.” 

On a separate note, Private Debt Investor will be doing its bit for charity in the coming months. In eight days’ time, your correspondent will be dragging himself up the Engadin valley in Switzerland. The Engadin Swimrunis just over 52km of running along the valley sides, and swimming across the various lakes that line the valley floor. I’m raising money for Combat Stress, a charity that supports service veterans experiencing mental health problems. Any donations would be gratefully received. To do so, click HERE.  

PDI (and colleagues from across PEI) will also be competing in a new event being run this year in support of the Impetus Trust and Private Equity Foundation, the Financial Times Triathlon. A team drawn from across our London office will compete in a relay triathlon on 13 September, one of several races being run at Olympic rowing venue Dorney Lake that day. The organisers are still accepting entries, and your support – either as competitors or via donations – would be much appreciated. For more information on the event, click HERE, and watch this space for further news of PEI’s fundraising efforts.