Why emerging markets are better prepared to cope with financial shocks

The increasingly important role that emerging markets play in world growth has become abundantly clear with the latest correction in global equity markets. At the end of May, the world market capitalisation of equities peaked at US$73 trillion. Since then, about US$13 trillion of that value has been wiped out. This sizeable correction started with a sell-off in China and Brazil, but this week it finally reached the Japanese, European and US markets. For the first time in recent history, it is a slowdown in the developing world that has served as the catalyst to rock developed markets hard.

The emerging markets have, for a few months now, been caught up in a tornado called "Fed policy", having had to anticipate "when and if" Janet Yellen's Federal Reserve Board will raise rates for the first time. This possibility has left the dollar strong against most emerging market currencies. The dollar's strength and weak commodity prices have together posed a significant challenge to growth internally and have squeezed the profit margins of many companies in emerging markets, as well. Deteriorating margins and a weak demand picture for global growth have made it difficult for companies operating in this region to earn a rate of return on their equity that meets their cost of capital.

Confronting this problem of slowing economic growth, 30 central banks have cut rates this year, hoping to devalue their currencies with a view to being able to increase exports to the rest of the world. This strategy, given the generally weak global demand picture in developed markets, has not worked out well for the emerging market countries: an increase in one country's share of exports comes at the expense of another's share, especially given that global growth in trade (measured in dollar terms) has actually been negative during the past two years. Does all this mean a doomsday scenario is likely for the developing market economies in general?

The answer is a resounding no. The emerging countries in aggregate have done significantly better at macroeconomic management this time compared with the shocks of the past two decades. Many of these countries have floated their currencies, paid close attention to their current account deficits, become more fiscally responsible and have amassed a sizeable foreign exchange reserve position that together has left them better placed to deal with increased currency, bond and equity market volatility. Their banking systems are better capitalised, and a significant part of their incremental indebtedness is now denominated in local currency (rather than US dollars).

Despite the dollar surge, falling commodity prices and some country-specific problems emanating from government scandals and geopolitical events (in Brazil and Russia, for example), total foreign exchange reserves in emerging countries are currently estimated at US$7.5 trillion. This covers about 11 months' worth of their imports. The simple adequacy rule of thumb for imports for a developing country is around six months of coverage.

To put the overall foreign exchange reserves number in perspective, total emerging market foreign reserves in 1999 stood at around US$610 billion. This level of foreign exchange reserves gives the bloc of emerging markets a reasonable cushion to cope with other unforeseen contingencies.

In previous economic cycles, many emerging market countries (such as Brazil, Mexico and Thailand) were plagued with runaway inflation, which made managing their domestic macroeconomic situations difficult. This usually meant central banks had to tighten policy and raise rates to combat inflation precisely when they should have been providing stimulus. Recently, however, most of the central banks in the emerging world (India included) have adopted inflation targeting as a core policy tool, giving them more latitude to be accommodative.

Unlike during previous crisis episodes, this time, most of the developing world is plagued with the problem of "missing inflation": the producer price index in China has been down now for 41 months in a row. Even in India, where inflation was stubborn all of last year, progress has been made recently in fighting it. Therefore, the monetary authorities in developing countries are in a much better position to be able to use a wide array of tools to respond to stressful economic periods. This is exactly what the People's Bank of China is currently trying to address the stock market rout and the slowdown in internal economic growth.

This raises an important question: what does all this mean for emerging market stocks?

What has plagued stocks in emerging markets can be traced to the systematic deterioration in net profit margins of companies there. For two decades, emerging markets' net profit margins were some 250 basis points better than companies operating in the developed world. But this differential flipped in the first half of last year, and emerging companies are now trailing their developed market counterparts by almost 100 basis points. This erosion in margins has lowered the return on equity of these companies, and many firms are not even earning their cost of capital.

One thing is certain: to achieve real global growth, developing markets will have to rely more on domestic-based growth, rather than the export-driven growth model of the past.

While each developing country will have its own nuance from a policy perspective, a move up in emerging market stocks will happen only when, first, net profit margins improve and, second, there is greater clarity as to when the US Federal Reserve will actually raise rates.

Guru Ramakrishnan is the CEO of the Meru Capital Group