Elizabeth Howard, Junior Consultant

The widely-cited case of Argentina has shown us that countries can ‘submerge’ just as easily as they ‘emerge’ and ‘re-emerge’. Today we are starkly reminded of this by countries such as Greece, Iceland, Portugal and to some extent, Spain and Italy, that have seen their sovereign debt ratings deteriorate and investor confidence evaporate in the wake of successive financial, economic and public finance crises. Cross-border contagion, a phenomenon typically associated with emerging markets, is currently raging in southern European countries. Many emerging markets have weathered the crisis substantially better than the ‘PIIGS’, which begs the question of the use and validity of the term ‘emerging market’. How have the risks associated with these countries changed over the past two decades?

The majority of emerging markets have experienced high growth rates since the turn of the century, and particularly during 2003-08. During the period 1990-99, emerging markets contributed around 46% of world growth of which 20% was attributable to the BRICs. During the period 2000-07, these figures grew to 65% and 38% respectively. This healthy growth has generally been nurtured in an environment of low and stable inflation, rising domestic demand and growing intra-regional trade. Exposure to the G3 countries has increased, but emerging markets are at the same time diversifying their trade toward other emerging markets.
 

Country risk fundamentals such as solvency ratios, international reserves and the balance of payments also reflect the improving macroeconomic environment in emerging markets. Indeed, the average credit rating of the countries included in the EMBI Global index improved from BB- to BB+ between 2000 and 2007, and sovereign spreads have compressed significantly across all regions since 2005.

EMBI Sovereign spreads (Source: JP Morgan, Datastream)

In a working paper, Howard (2008) isolates six variables that impact the stock market volatility of emerging markets:

Local variables:
> EMBI sovereign spreads, a proxy for country risk
> Nominal exchange rate
> Herfindahl index of market concentration

Global variables:
> Fed funds target interest rate
> Oil price ($/bb)
> VIX index, a proxy for risk aversion

Using a simple time series regression model with stock market volatility as a dependent variable, the author examines the impact of these variables over two periods: 1994-1999 and 2000-2010.

The results for the period 1994-1999 show that sovereign spreads are significantly positively related to stock market volatility for all countries except China. The other local variables, the nominal exchange rate and Herfindahl index, have significant coefficients but with different directions of influence across the countries. Higher index concentration is generally associated with higher stock market volatility (Russia, Thailand and Turkey), but is negatively correlated in the case of South Africa.

Amongst the global variables, the US key interest rate and the oil price are significantly negatively related to stock market volatility, acting as bear market indicators. Correlation between global risk aversion (VIX index) and emerging market stock volatility appears to be negative during the 1990s, indicating the lack of market integration.

Over the period 2000-2010, the impact of the spread has declined in advanced emerging markets such as Brazil and South Africa, reflecting the greater macroeconomic and political stability. The nominal exchange rate remains negatively related to volatility in countries with commodity currencies such as South Africa and Russia. The VIX index is now significantly positively related to volatility in three countries.

Spread JPMVXYEM - VIX Vs. MSCI EM 3-month Volatility (Source: JP Morgan, MSCI, Bloomberg)

The risks, as well as the benefits associated with emerging markets are thus shifting: more stable economies reduce the macroeconomic and political risks that discourage investors. At the same time, greater integration allows global risk-sharing but aggravates contagion and diminishes opportunities for portfolio diversification.

Looking at a wider horizon of time and space, it is perhaps futile to attempt to categorize heterogeneous countries with evolving political and economic landscapes. (This creates expectations, and thus surprises, which in turn creates excess volatility and contagion). However, investors need horizons and categories for asset allocation, and the current uncertainties surrounding developed world public debt will at least introduce some nuance into the labels “emerging” and “developed” markets.