We present to your attention a new report of the SKOLKOVO Institute for Emerging Market Studies (SIEMS), which examines a large swath of financial market indicators to assess just how far the emerging economies have increased their financial development and strength over the past decade. This brief review will give key theses, analysis data and SIEMS experts’ conclusions.
The Great Risk Compression
By far the most important development in the emerging financial markets over the past decade has been the massive compression in perceived risk. Emerging markets (EMs) have traditionally been characterized by having much higher levels of financial risk relative to developed economies.
For the first time, some EM market countries are now judged to be less risky borrowers than several western European countries. Some analysts have voiced concern over the scale of the inflows into EM debt securities since the end of the global crisis, viewing the risk premiums as entirely too narrow for economies that are still “emerging”. Others, however, believe that fundamentally, EMs are just a lot less leveraged now and simply have the financial strength to repay their loans.
EM Equity Market Development
This year the EM economies are expected to account for 30% of world GDP (at cur- rent exchange rates), which is now approximately equal to its share of total global equity capitalization. Much of the deepening in emerging equity markets can be attributed to developed market investors, seeking both higher returns and portfolio diversification.
Global Equity Market Capitalization Shares
The change in equity market shares over the past decade has been significant. The US, EU and Japanese share declines of 14%, 10%, and 3%, respectively, were offset by sharp increases in the EMs’ shares. Many financial economists consider a nation’s equity capitalization ratio (stock market capitalization as a share of GDP) as the best broad-based measure of the financial development of a country. If so, many emerging markets seem to have obtained developed market status over the past decade.
If the number of stock listings is indicative of shifting strength of a country’s financial markets and the activeness of the financing and investing behavior of the corporate sector in a country, then the US is quickly fading. The number of US stock listings has fallen by 43% since its peak in 1997. During this same period, the number of listings outside the US has more than doubled. The result is some 3,800 fewer companies trade on the US exchanges today than in 1997. At 314, Russia has the fewest listed companies among the larger emerging market economies.
Emerging Corporate and Sovereign Debt Markets
The overall credit quality of EM countries has improved dramatically over the past decade. One of the primary reasons has been the improvement in sovereign credit quality. EM countries have decreased their need for borrowing, shrinking the overall supply of sovereign bonds globally. Approximately 60% of EM countries are currently rated investment grade, up from just 2% in 1993.
EM companies are increasingly tapping the public credit markets to finance growth and these corporate bonds are now becoming a major part of the broader emerging market investment universe.
Foreign Exchange Reserves
While the developed world still accounts for the bulk of FX turnover, it is the EM economies that now account for the lion’s share of FX reserves.
From the 2000 to 2011, EM’s share of global FX reserves more than doubled, rising from 32% to 67%.
Emerging Market Exchange Rates
As relative financial strength shifts between nations, so should the relative strength of their respective currencies. Emerging market currencies are generally expected to appreciate over time as their real GDPs approach purchasing power parity. The currency appreciations are an important element over time because it gives EM nations greater purchasing power over global assets and goods.
China’s rapid financial development has brought much speculation about how quickly its currency, the renminbi, could obtain major reserve currency status. But most analysts believe that full convertibility, the only measure that could eventually make the yuan a major reserve currency some day, is still a long way off.
Emerging Market Banking
The banking sector is a critical part of the financial system in the EM coun- tries. It is the major financing source for both the private and public sectors thus serve as the crucial engine for economic growth in these countries. The banking sector has become increasingly the major funding source for firm investments in these countries. According to a World Bank study, only 11% of EM firms relied on banks for their investment in 2002, while the figure rose to 31% in 2009.
The financial crisis and Great recession of 2008 abruptly and brutally end- ed a three-decade long expansion in the global financial markets. While the worse of the crisis has past, as of this publication (August 2011), much of the world’s rich developed economies and financial markets remain precariously weak. Financial activity and development in the emerging world, however, has picked up where it left off before the crisis and is surging forward. And perhaps most interesting, global investors are no longer treating emerging markets like emerging markets. The risk premium associated with EM financial securities has shriveled away to almost nothing.
Going forward, the EMs will need to continue deepening their financial markets if they want to reach the next stage of economic development. That will require further financial liberalization and a regulatory structure that encourages innovation but not moral hazard. They should take the recent events in the developed world as a lesson in not what to do.
For more details of the research and results, read the full report.