Focus: Global Emerging Markets

Sixty five years after the establishment of the Bretton Woods World Order, political and financial leaders have reluctantly understood that it’s time for a renovation of its architectonics.

Going through the financial turmoil mistakenly referred to as the Asian Crisis of 1997-01 should have been a wake-up call, but world leaders did not recognise this for the first global crisis that it was. That crisis could have been contained within several Asian countries, but governments and multilateral institutions were afraid to intervene.

The millennium marked the end of a period of romantic capitalism. The Asian crisis provided a good lesson for the leadership of several countries; lessons that were unfortunately not heeded by multilaterals, who did not change their functions or responsibilities. This is why, when the world crisis of 2008 hit the economy, it was not predicted by a single multilateral organisation, nor did any of them stand up to say they should have sent warning that it was coming.

Unlike the multilateral institutions, the governments of several countries took the lessons learned from prior turmoil and intervened aggressively with new restorative regulations to stem the spread of the meltdown. They bravely used the few instruments available: injecting huge amounts of liquidity, decreasing interest rates to make money and governmental credit accessible, and modernising bankruptcy law and real estate regulations.

The most important consequence of this crisis has been a new level of understanding of systematic and unsystematic risk by the investment community. It has become evident that as the potential for high, speculative returns grew, investment in under-regulated hedge funds and derivative instruments overwhelmed those in the traditional, regulated financial system.

The most dangerous aspect of this trend happened when derivative investments collided with the growing investment in emerging market countries (EMCs). Non-existent at the beginning of the 1980s, EMCs have consolidated into a global emerging market (GEM) in a mere 25-30 years and now contribute more than 51 per cent of the global output. Based on my evaluation, 83 countries belong to the emerging market category and they cover almost 45 per cent of the world’s territory. The financial systems and capitalisation of the individual national economies of the GEM are growing much more quickly than those of the developed nations.

The institutions and companies of emerging market countries are often managed by individuals who have less experience and training than their colleagues in developed nations. For this reason, it is not surprising that their use of derivative instruments has been less effective and more dangerous. This problem was multiplied by pressures presented by investors from developed nations, who were looking for investments in risky emerging markets only with the expectation of substantially higher returns. This factor brought the problem full circle.

As their returns grew, companies from developed countries became obsessed with the opportunities presented in emerging markets. Companies not only increased their portfolio investments, but began to place direct investment as well. It is natural to invest in stable domestic political, economic and business conditions during an economic boom, but these idealistic conditions do not exist in real business life.

This is why with speculative interests for higher returns, companies began investing in derivative instruments in the GEM as well as highly dangerous foreign direct investment (FDI). The risk of FDI is an innate characteristic of cross-border business from developed to emerging markets and is related to the threat of predictable or unpredictable negative changes of the external environment or of a company’s internal resources, with manageable and unmanageable consequences leading to potential losses. All of this created the best preconditions for a domino effect leading to a global crisis.

The ever increasing integration between the markets of developed nations and those of EMCs has meant that domestic instability can quickly lead to a global crisis. When, in September 2008, Wall Street experienced its first shock with the monumental collapse of Lehman Brothers, the effect on EMCs where Lehman and its clients held either portfolio or direct investments was immediate.

Additionally, when foreign investors began defensive manoeuveres and started to withdraw their capital from emerging markets, they frequently became the victims of fraud perpetrated by their local partners and were forced into expensive litigation. The settlement amounts were frequently far outweighed by the cost of the proceedings and the inquiry into plaintiff’s reputations in the international business community.

Only now, when the crisis is mostly over, foreign investors from developed countries have recognised how dangerous it had been to enter emerging markets with FDI without serious upfront due diligence. Through painful lessons taught by 18 months of financial upheaval, companies discovered that going to court against their local partners is not a good idea. Even if the foreigners manage to get the upper hand through the courts, depending on the EMC and its level of law and order, this may not translate to a settlement in real business life, which in some cases is unfortunately still resolved with bullets in the street.

Despite the risks, it is still necessary for companies from developed nations to invest in EMCs, otherwise their competitors will come back to their home markets with profits enabling them to win domestic competitions. This is why, for any company entering the GEM, the strategic decision-making process must be oriented to deal with high levels of political, business and technological risk. The high involvement of EMC governments in business activity can increase the risk of breached contracts.

Another specific of the EMCs is title risk, which is higher than in developed nations. In the overwhelming majority of EMCs, the process of privatisation has only recently finished and companies that received FDI have their own problems with clean titles. This is especially related to those EMC’s in which the process of restitution is not yet complete, or hasn’t even started.

Quite frequently, a high return on investment in EMC’s may be the result of an under-developed framework and/or less restrictive environmental regulations than in developed countries. In some cases, systematic risk is high, but there are special laws protecting foreign property in order to attract FDI. The existence of such specific protection of foreign property and its enforcement is one of the main distinctions between EMC’s and under-developed countries.

If a country has a lack of transparency in capital markets and an absence of branches of major global commercial and investment institutions, foreign investors are driven away. This is why despite having a lot of mutual characteristics, EMCs are not homogeneous. The significance of differences is amplified when institutional or even public investors use unverified information to make their strategic investment decisions.

The lessons of the current global crisis for multilateral institutions, national governments and public and private investors, despite their varying interests are mostly the same. The new global order needs at least three new, small, but efficient and independent institutions.

• An institution to monitor the world economy and inform the global community when leading indicators appear to indicate a potential, even a weak crisis.

• It is necessary to create a multilateral ratings agency which will be prohibited to provide any other institution, be it private or public, with consulting services in order to avoid conflicts of interest that may compromise accuracy of the ratings. As a reminder, one day before its failure, Lehman Brothers had a AAA rating from the majority of private ratings agencies.

• A new global entity must be created to regulate the implementation and use of new, previously unregulated, financial instruments and funds.

The overall recommendation for the global investment community is to recognise the inevitability of portfolio and direct investment to EMCs, the role of which will increase tremendously in the next 15 years. To understand this, it is important to underline that among the top 10 countries in terms of GDP, there are already four emerging markets (China, India, Brazil and Russia) and South Korea is quickly approaching this list. As of January 2009, 43 per cent of all FDI went to EMCs. As this percentage continues to grow, the modern global marketplace and its institutions will be substantially altered.

Dr Vladimir Kvint is a Member of the Bretton Woods Committee (Washington, DC) and Chair of the Financial Strategy Department, Moscow State University’s Moscow School of Economics. He is a member of the Board of international architecture firm RMJM and advises the company on their growth strategy for emerging markets.

He will give a free public lecture, The Global Emerging Market and its role in a time of crisis, at the London School of Economics and Political Science at 6.30pm on Monday 5 October. For more details visit

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