Are Emerging Markets Proving Their Detractors Right?

After more than a decade as the darlings of the investment world, Emerging Markets (EM’s) have fallen out of favour rapidly as it becomes apparent that they are not following the linear path to prosperity that many had envisioned. Whereas previously the investment world focussed on the seemingly unlimited potential of billions of new consumers, recent events in such disparate countries as Turkey, Thailand, Nigeria and Ukraine highlighted the fragility of governance and institutions that is typical of emerging markets. Other EM’s such as South Africa, Brazil and India have not seen political crisis, but have still come under scrutiny due to their falling growth rates and rising inflation.

Over the last decades, EM’s have been the beneficiary of massive capital flows, partly due to their potential for economic growth, but in recent years also due to the flood of money brought on by ultra-easy monetary policy (low interest rates and quantitative easing) in developed markets. With the prospect of ultra-easy monetary policy coming to an end, EM’s will have to provide an attractive environment for capital in order to fund their investment plans. Sceptics contend that most EM’s are stuck in the "middle-income trap”. The theory is that an EM can grow from being a poor country to a middle-income country by capitalising on natural resources or cheap labour, but it then gets stuck in a “trap” when it does not have the strength of educational, legal and social institutions necessary to continue its development into a higher-income country. Capital flows are not effectively absorbed into the economy but instead they fuel a temporary consumption boom. A consumption boom without improvements in productivity eventually leads to a crisis followed by a reversal of capital flows. While each EM has its own unique circumstances, this sequence of events does seem to accurately describe many countries in the EM universe, including Turkey, Brazil, India and South Africa.


Recent events have highlighted the weakness in EM institutions, and their ability to negatively impact the growth potential of a country. In Turkey, Prime Minister Erdogan seems to be turning into the autocratic ruler that many had been warning of. The recent corruption scandal has seen him launch an offensive against the judiciary and police the media, and now even the Internet. Turkey’s mishandling of their monetary policy over the last year, also due to political pressure, has resulted in a dramatic fall in the currency. Nigeria has experienced rapid economic growth in recent years despite its high level of corruption. The firing of Reserve Bank governor Sansui after he exposed a $20bn hole in the state oil company’s finances highlights how weak Nigerian institutions are. Investors see immense potential due to the population of 170 million people, but this potential won’t be realized if the state continues to mismanage the economy.

On the ground in South Africa, we are painfully aware of the difficulty of generating a level of economic growth necessary to reduce unemployment, poverty and inequality. SA has struggled to generate more than 2% growth over the last 2 years and it clear that development has stalled. While SA’s institutions are amongst the strongest in the EM universe, the country is constrained by poor educational outcomes that limit productivity growth.  Recent years have also been characterized by deterioration in the efficiency and effectiveness of government institutions. This has created a high level of uncertainty that has limited investment in the economy.

As a citizen of an emerging market, I am not just an impartial observer in the recent reversal of fortunes. Whilst I think that the euphoria around EM over the last decade was in part due to ignorance about the developmental challenges these countries face, the current pessimism (and market valuations) seems to imply that progress has permanently stalled. EM may currently be regarded as a poor investment destination, but if governments can create the right environment then convergence can resume and EM’s can outperform developed economies for a considerable period of time.

$19 Billion, Whatsapp with that?

The news today that Facebook was buying messaging app "Whatsapp" for an amount of 19 Billion dollars was greeted mainly by shock in the financial media. While most agreed that the amount is excessive for a company which in 2013 had $20 million worth of revenue, some have tried to justify the valuation based on the potential future profits if Whatsapp is able to eventually monetize the user base. Recent tech acquisitions (Instagram, Nest) and the valuation of companies such as Facebook, Twitter and Tencent have drawn comparison with the 90's tech bubble, but i think this is the clearest example that we are actually in the middle of a tech bubble.

Firstly we have the absurdity of Henry Blodget chastising us for thinking that $19Bn is too much http://www.businessinsider.com/why-facebook-buying-whatsapp-2014-2. Blodget is the founder of "Business Insider" and was one of the original internet stock gurus, touting internet stocks like etoys.com publicly while referring to them as "junk" in his private emails.

Secondly we have the re-emergence of financial metrics that may have no relation to how much profit the business is actually making. We now see tech companies again being valued on metrics such as "price to sales". In the case of social media companies and now messaging apps "price per user" is used to justify a high valuation in the absence of revenue. Whatsapp ostensibly charges $1 per year for each user, but no one actually seems to pay it. A big part of why Whatsapp's user base has grown to an impressive 450 million is that HAS no revenue model (ie it is free). If it did have a revenue model it would not have 450 million users.

I have used whatsapp almost exclusively for the last few years and its speed, ease of use and lack of ads has made it the standard here in South Africa. Their implementation has been excellent and far superior to similar apps which were launched at the time (eBuddy is one i tried but it was slower and full of ads). While Whatsapp is touted as the fastest growing social media app of all time, network effects in instant messaging are much lower than social media and it is a business which is easily to replicate.  Most people have several messaging apps on their phone and can easily switch if necessary. I can also see Apple (iMessage) or Google (gchat/hangouts) launching cross platform "whatsapp" style versions of their messaging apps in the same way as Blackberry did with their BBM messenger. An offering from Apple or Google will be a compelling alternative, and mean that Whatsapp will never be able to monetize their offering as it would risk destroying their user base.

One mitigating factor in the valuation of the transaction is that only $4 billion of the purchase price is in cash, with the rest in settled in Facebook’s expensive (50-110 PE) stock. This makes the headline purchase price somewhat academic.

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On a side note this transaction got me thinking about the nature of implementation and luck in internet start-ups. In South Africa there was a free messaging app called Mxit which was launched around 2003 and was the messaging standard among South African youth for most of the decade. It but it began to lose favour towards the end of 2010 with the proliferation of smartphones and Blackberry messenger. While it still exists today, and recently launched in India, it has been through several management changes and seems unlikely to survive. What amazes me is that this free messaging app predated whatsapp (which launched in 2009) by about 6 years, an absolute age in the tech industry. Even though Naspers, SA's biggest media and technology company, purchased a 30% stake in 2007, Mxit never managed to expand their reach or capture a user base in the way that whatsapp was able to so quickly after its launch. I would be very interested from those close to the story to understand why.

Why the SARB Had to Hike Rates

I attended a lunch today with Brian Kahn, a member of the Monetary Policy (MPC) committee who has been with the South African Reserve Bank (SARB) since 1999. We had met with him a few months ago and he used this meeting to again emphasise that the SARB would follow a conventional inflation targeting framework. He also confronted the issue of the SARB's communication strategy, given that January's rate hike was a surprise to all 25 economists polled by Bloomberg. Brian indicated that the MPC had sufficiently communicated the risk of a hike in its two previous hawkish MPC statements, something I had previously highlighted.

(http://rashaadtayob.blogspot.com/2014/01/economic-conformity-all-25-economists.html)

A lot of time at the lunch was spent discussing the monetary policy framework, the views of the various committee members, as well as the domestic economy and the effect of interest rate hikes on growth. My interpretation of the SARB's thinking is that they react primarily to 3 factors:

1) Inflation
2) Growth
3) Global Rates/Liquidity

Where I think local economists got it wrong was that they spent a lot of time focusing on the domestic environment (1 and 2). They looked at the poor growth outlook and the relatively muted inflation data and concluded that there was no need to hike rates. Many economists thought that rates would remain on hold throughout 2014. My own view is that global interest rates (3), is the overriding factor, and the SARB doesn't have as much choice in its policy as it or economists/analysts thinks. The following chart (source: Bloomberg) shows a long term history of SA's Prime Lending Rate and the FED Funds target rate. 

From this 30 year history it is clear that SA rates are very much a function of the global interest rate cycle, of which the FED is the biggest driver. The cycle has been different this time in that the FED resorted to quantitative easing programs once they had reached the zero bound of interest rates. These QE programs achieved their aim of creating liquidity conditions commensurate with a negative Fed Funds rate. Once the FED began the process of tightening monetary policy in May by announcing the tapering of QE, SA rates could not remain at their record low levels and rate hikes were inevitable. 

Don't Blame Us, Blame the Financial Crisis

In last night's state of the union address, President Zuma explained that the depreciation of the Rand was not due South Africa's economic policies, but rather "global economic problems". Blaming SA's economic malaise on global factors was a constant theme throughout 2013. In our meetings with government representatives and managers of state owned enterprises over the course of 2013, the consistent message was that South Africa was victim of the global environment. Rather than confronting the problem of SA's declining competitiveness and taking steps to improve infrastructure efficiency and cost,  SA's politicians have sought to place the blame solely on the troubled global economy. As one would have expected the results of this approach have been poor.

Whilst the weakness of the global economy has obviously been a headwind and EM currencies have depreciated over the course of 2013, the argument that SA's poor economic performance is all down to to global factors does not hold due to the fact that :

1) The Rand has been the weakest performer in the EM universe (Chart 1 from Bloomberg)
2) SA industry has lost significant market share due to declining competitiveness (Chart 2 from Macquarie)

South Africa's weakening fundamentals and poor policy are reflected in the fact that the Rand has been among the weakest performers since the beginning of 2013. Countries which have been proactive in addressing economic imbalances and competitiveness have seen far less currency weakness than SA's 22% depreciation.

Chart 2 shows the decline in South Africa's global market share of services exports. While fellow emerging market countries such as China, India, Russia and Brazil have increased their market share significantly over the last 10 years, South Africa's share has been in continuous decline. A similar picture emerges in the traded goods sector, where the competitiveness  of the mining industry has been impacted by the dysfunctional relationship between labor and business.

Despite government assertions to the contrary, politics has played a significant part in South Africa's economic downturn. The inefficient roll out of infrastructure has resulted in a rapid increase in costs born by business, while government has stood by as labor relations in the mining industry have collapsed. Government's unwillingness to confront the declining competitiveness of the economy means that we are unlikely to see a structural recovery, and the target of 5% GDP growth will not be achieved.