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Emerging Market ETFs: How to Pick Winners?

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Past few months have proved to be quite ugly for emerging markets investments. While these markets in general had a lackluster performance earlier this year, investor sentiment deteriorated rapidly after the Federal Reserve hinted at scaling back its asset purchases. Stock markets in these countries suffered steep declines and currencies rout further added to the pain.

Emerging economies had been dealing with the problem of excessive capital flows until just a few months back. Ultra-low interest rates in most developed economies sent trillions of dollars to emerging countries in search of higher yields and growth opportunities. The reversal began with the ‘taper’ talk even though actual tapering is yet to start. (Read: 3 Cyclical ETFs for an Improving Economy)

While the markets seem to have stabilized as of now, the problem remains unresolved and we will most likely see another round of panic when the Fed actually starts reducing the asset purchases.

At the same time, many analysts believe that the sell-off has been overdone and some of these markets offer excellent long-term investment opportunities at current valuations.

Remember that these countries are still growing at much higher rates than the developed world. Per IMF’s World Economic Outlook (updated in April 2013), developing economies are expected to see growth rates of 5.0% and 5.4% respectively in 2013 and 2014, compared with 1.2% and 2.1% for advanced economies.

However, growth rates for emerging economies will most likely be revised down slightly at the time of their next update in October and the rates for the developed economies may go up thanks to better than expected recovery in Europe and Japan.

With rapidly changing emerging markets investment landscape, it is time to delve deeper into country fundamentals before deciding where to invest. (Read: European ETFs-A Surge in Popularity)

Hot Money Flows Reversals—Which Countries are most vulnerable?

Countries that are dependent on ‘hot money’ to finance their external deficits are the most vulnerable to rising interest rates in the US.  These countries largely depended on cheap foreign capital to finance their capital account deficits. Other key factors to consider are ratio of short-term  external debt to foreign exchange reserves and the ratio of volatile capital flows to total flows.

Countries have a large oil import bill, like India, Turkey and Indonesia and Thailand remain vulnerable to any spike in oil prices if tensions in the Middle East escalate again.

  Current A/c Balance (% of GDP) Stock Market Performance (YTD) Currency Decline Against USD (YTD)
Turkey -6.8% -16.3% -12.9%
South Africa -6.4% 10.9% -16.7%
India -4.9% 2.9% -14.9%
Indonesia -3.3% 1.0% -17.8%
Brazil -2.4% -11.4% -11.1%
Thailand 1.1% 0.1% -4.4%
Philippines 2.0% 4.8% -6.8%
Mexico -1.0% -4.5% -1.5%
South Korea 2.7% -0.1% -2.1%
Malaysia 5.7% 4.5% -6.7%

Did Policy Actions Succeed in Halting the Slide?

Sudden flight of capital has left many central banks struggling to come up with appropriate policy responses. Brazil’s central bank announced a $60 billion intervention program to halt the currency slide and has raised the rates for the fourth time since April.

While several earlier measures announced by the Indian central bank to slow the outflows had backfired as market participants feared that country may be moving towards stricter capital account controls, some later market friendly proposals made by the new central bank governor raised some hopes about the economy. (Read: India ETFs Rebound on Central Bank Steps)

By some estimates Indonesia and Turkey spent between 15% and 25% of their foreign exchange reserves in trying to protect their currency. Indonesia and Turkey also raised their rates to try to attract the capital back to the country.  Howver these currencies are still down in double digits against the the US dollar.

Countries like South Africa which do not have enough reserves and further do not have much flexibility to raise rates in view of alarmingly high employment rate, are at highest risk. No wonder the currency has lost about 18% against the US dollar.

Is a Repeat of 1997 Possible?

Many emerging countries have accumulated large holdings of foreign exchange reserves, as they tried to halt the appreciation of their currencies in the face of strong capital inflows duing the past few years.

Reserves give them some flexibility to prevent or at least decelerate the slide in their currencies when hot money suddenly flows out. Further, most of them have flexible exchange rates unlike in 1997 when countries with fixed exchange rate regimes were forced to devalue their currencies.

In fact, they are more likely to allow the currencies to decline moderately as weaker currencies will make exports more attractive.  At the same time, they are prepared to intervene in times of excessive volatility.

Strong Leadership and Structural Reforms Necessary for Long-term Success

For long-term success, macroeconomic platforms in these countries have to be supported by structural reforms. Countries that have failed to institute market friendly measures are likely to be punished by foreign investors in coming years. Mexico which has been a frontrunner among the emerging markets in the area of structural reforms, managed to largely avoid the meltdown.

Rampant corruption and brazen populist policies being adopted by the ruling parties have only added to the woes in countries like India and Indonesia. (See: Russia ETFs-Immune to Emerging Markets Weakness)

Current political leaders in Mexico and Philippines have also demonstrated strong resolve to tackle corruption and in fact they have been very effective in bringing down corruption and tax evasion.
The Bottom Line

While the imminent end of the era of cheap money is one side of the story; at the same time, not all emerging markets are the same. Current crisis has just brought to the fore the structural problems that were already existing in some of these countries. Countries like India, Indonesia, Brazil, Turkey and South Africa are most likely to continue to suffer in the coming years.

On the other hand, countries that have instituted structural reforms at making their markets open and competitive in the long term will emerge as long-term winners.

Mexico, South Korea and Poland have largely avoided the melt down due to their lower dependence on hot money and sound macroeconomic fundamentals. As growth in China picks up, Philippines and Malaysia could also benefit.

Mexican currency displayed remarkable resilience when other emerging markets currencies suffered steep declines. The outlook for the ETF tracking the country--iShares MSCI Mexico Capped Investable Market Index Fund (EWW - Free Report) )—has also improved as US economy picks up momentum as about 80% of Mexico’s exports go to the US.

South Korea has greatly reduced its dependence on external capital after the 2008 crisis and with excellent institutional framework and open market policies, the country could be poised to deliver excellent returns over long-term. Further as global economy continues to slowly recover, iShares South Korea ETF (EWY - Free Report) should benefit from its focus on export sector.

With its sound economic fundamentals and strong policy frameworks, Poland looks like a winner among the emerging Europe nations and ishares Poland ETF (EPOL - Free Report) could be an interesting investment pick now with easing of the headwinds from the rest of Europe.
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