Emerging Markets in an Upside Down World

Challenging Perceptions in Asset Allocation and Investment

Jerome Booth

• Publisher: Wiley
• Year: 2014
• ISBN:
  9781118879665
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

The world is upside down. The emerging market countries are more important than many investors realise. They have been catching up with the West over the past few decades. Greater market freedom has spread since the end of the Cold War, and with it institutional changes which have further assisted emerging economies in becoming more productive, flexible, and resilient. The Western financial crisis from 2008 has quickened the pace of the relative rise of emerging markets - their relative economic power, and with it political power, but also their financial power as savers, investors and creditors.

Emerging Markets in an Upside Down World - Challenging Perceptions in Asset Allocation and Investment argues that finance theory has misunderstood risk and that this has led to poor investment decisions; and that emerging markets constitute a good example of why traditional finance theory is faulty. The book accurately describes the complex and changing global environment currently facing the investor and asset allocator. It raises many questions often bypassed because of the use of simplifying assumptions and models. The narrative builds towards a checklist of issues and questions for the asset allocator and investor and then to a discussion of a variety of regulatory and policy issues.

Aimed at institutional and retail investors as well as economics, finance, business and international relations students, Emerging Markets in an Upside Down World covers many complex ideas, but is written to be accessible to the non-expert.

Chapter 1

Globalisation and the Current Global Economy

‘Globalisation should not be just about interconnecting the bell jars of the privileged few.’

De Soto (2000, p. 219)

‘The benefits of globalization of trade in goods and services are not controversial among economists. Polls of economists indicate that one of [the] few things on which they agree is that the globalization of international trade, in which markets are opened to flows of foreign goods and services, is desirable. But financial globalization, the opening up to flows of foreign capital, is highly controversial, even among economists…’

Mishkin (2006)

In this chapter we discuss some of the background to attitudes towards money and debt. We explore the historical erosion of despotic power. We aim to understand globalisation, both ancient and modern, identifying the trends most important for current events and policy actions.

1.1 WHAT IS GLOBALISATION?

Globalisation has been through a number of cycles including in the nineteenth century period of free trade.¹ The term requires careful use: its range and ambiguity in common parlance can cause misunderstanding.

Globalisation is both a state and a process. It has an economic facet, perhaps best described as the greater interconnectedness of trade and investment as transactions costs and barriers reduce, but also the idea of lack of constraint on markets by government. It is this element that investors are ultimately most interested in. But globalisation also has a technological aspect (not distinct from the economic aspect), notably as represented recently by innovations and speed in modern communications. And it has a cultural facet, as exposed in the spread of common means of entertainment and ideas. It homogenises, and through standardisation commodities, but also creates diversity of choice; complicates and simplifies; brings benefits and conflicts; produces winners and losers.

For emerging markets today, globalisation accelerates convergence to the living standards of developed markets. For some, in a world in which the voices of those with something to lose are louder than those who gain, the term is laced with emotive content, often negative, and while it creates jobs and wealth, globalisation is, for many, associated with job losses and erosion of local values.

Ridley (2010) argues that, among other things, it was trade which propagated innovation technology and civilisation, as do Findlay and O’Rourke (2007). Jane Jacobs in her book Systems of Survival (1992) uses a Platonic dialogue to describe the different logics of politics, which is a zero-sum game, and commerce, a positive-sum game. Nations have historically competed for scarce territory, which, if one gained, another must lose; whereas both parties gain from a trade freely entered into.

If we want to avoid conflicts, commerce has a positive role to play. It is no mere historical coincidence that periods of protectionism and limited international trade often precede wars. The failed logic of isolationism and of fighting over land and other limited resources leads from mercantilism to gunboats, to strategic invasions of third countries, and to empire. Empires fall, however, or at best are managed into relative decline. The human tendency to barter and trade is certainly older than recorded history, and has long been geographically broad in extent. Though this is a generalisation, in the progress of greater economic interconnectedness there are waves, affected by human policy and history, as well as trends, driven by technology. Wars of the ‘hard’ and trade variety, restrictions on economic activity and trade, mass migration and natural disasters have all been disruptive but also sometimes stimulate innovation and new forms of economic activity. In contrast, political stability and incentive structures compatible with innovation have generally nurtured both existing patterns in trade and globalisation.

Braudel (1998) in his history of the ancient Mediterranean world argues that early transhumance (seasonal migration between summer and winter pastures) established a pattern of seasonal trade in the region. The world has clearly seen ebbs and flows in the extent of trade links and civilisations. Toynbee (1946) and others have categorised the rise and fall of civilisations, and with them trade and international links. The story of lack of stability wreaking havoc on economies and trade has repeated itself many times. Globalisation can and does ebb as well as flow. Technology has reversed on occasion as inventions have been forgotten once civilisations collapse. Our European Renaissance is in name a rediscovery. Arguably, however, it takes the destruction of civilisation to reverse technology, and in the modern era, as during periods of stability within earlier civilisations, it has been tenacious and non-reversible.

Technology profoundly impacts globalisation. It can aid economic growth, productivity and, by reducing transport costs, trade. Technology, by changing relative prices, also changes our institutions, as Douglass North (1990) has taught us. For example, technology effects disruptive upheavals in communication from time to time. Neil Postman (1985) has described how the written word, printing and then newspapers changed the pace and nature of interconnectedness. For example, in the 19th century, the telegram helped create the commercial success of newspapers and their news – the interest and novelty of new information from a long distance being of interest primarily, if not solely, because it was new. This ‘news’ content eroded and then eclipsed more considered thought, telescoping cultural knowledge and political debate to focus more heavily on the near present. Thus with the telegram came the modern newspapers, and with them came trivia, including the invention of the crossword puzzle – to test the reader’s knowledge of news trivia.

Subsequently broadcasting has impacted our communication patterns: for example, in the 1850s US presidential candidates would deliver speeches several hours long in public debates, long enough to justify meal breaks. That voters would spend the time to listen to such debates, and that they could comprehend the complex structured paragraphs which were so characteristic, stands in stark contrast to the norm of exchange so typical today.

Have we since ‘dumbed down’, and does the process of globalisation contain a series of dumbing-down episodes? Not entirely: the telegram, newspapers and then radio and television created a breadth of participation in culture not previously experienced. Political debates became less elitist and more inclusive, with more elite communication and interaction continuing, but less dominantly – less unchallenged.

The perception of dumbing down, and indeed the collapse of our sense of history to a more myopic immediate past, is clearly a strong one but not just a 19th-century one. The impact of television is an issue studied by Postman and especially in the post-Second-World-War US context by Robert Putnam (2000). His book Bowling Alone created a vigorous debate about whether television has been the main factor behind the postwar decline of US civic culture (an example of which has been the decline of community bowling alleys). Cries of ‘Dumbing down!’ go all the way back in history. The move from the oral tradition to the written word was lamented in ancient Greece and seen as destructive of the memory skills developed in the time when Homer’s ‘Iliad’ and ‘Odyssey’ – arguably still the greatest epics of literature – were related by word of mouth.² Broad access to books, particularly the Bible in 16th-century Europe, facilitated religious revolution and war. Dumbing down may look sacrilegious to an elite,³ but while it may represent a destruction of the means of valuable interchange of ideas, at the same time it can be revelatory and intellectually enriching for many more people not previously communicating with each other.

Technological change in the media has been not only traumatic but also irresistible as old technologies have been replaced. It affects the way newer generations think and interact. There is a feeling of erosive unstoppable destruction of the old as globalisation, via new media, invades. New technologies and the young bring myopia and collective amnesia. Older generations and traditional societies alike feel the tension as their children and communities adopt new modes of speech and ways of thinking and abandon the past. And this is not new. We may fear (or embrace) such change but we can’t credibly blame (or give all the credit to) our children. Globalisation may be a more convenient and acceptable receptacle for our emotional discomfort.

Modern communications have massively increased information flow, and the technologies of the Internet and mobile phone have leapfrogged older technologies in many developing countries.⁴ As with technological change before, much of this is inexorable and non-reversible. Knowledge of the wider world and aspirations for a better life combine in emerging countries to increase awareness. As populations become more vocal, this leads to pressure on elites for political and economic reform at home.

Economic growth and international competitiveness is in part the result of greater entrepreneurial opportunities. Others leave and migrate to the developed world, competing in labour markets there. Either way, the result is greater economic competition with the developed world, which either has to adapt or face job losses from increased competition. Thus many in the developed world feel threatened by globalisation, while at the same time it opens vast new opportunities to many in developing economies.

Part of globalisation is significant international trade, and also substantial cross-border flows of factors of production (capital, labour, technology). These flows take advantage of pricing differences, but in the process, also help reduce them – globalisation helps move the global economy towards an equalisation of returns to factors of production. It also involves multilateral production, and with it the spread of ideas and technology. There is greater openness to foreign inward investment. There is competition between governments for that investment, and for the jobs and knowledge which come attached. Different parts of the same production process may take place in several countries, exploiting comparative advantages. This is made possible by sufficiently low levels of protectionism and reliable low cost transport.

1.2 ECONOMIC HISTORY AND GLOBALISATION

To concentrate on the economic facets of globalisation, it may be useful to consider its historical precedents. Large-scale globalisation is not new. Maddison⁵ argues that ‘[i]n proportionate terms, globalisation was much more important from 1500 to 1870 than it has been since. A great part … due to gains from increased specialisation and increases in the scale of production’. International trade and capital flows are much larger today, but so is the global economy. There was an interruption as the world went to war in the 20th century, and then protectionism was only reduced gradually, but globalisation is clearly not a novelty.

There are also long economic waves of concern with inflation and deflation. Allen (2005) for example argues that the inflation of the 1970s was partly born from the concern over employment that had previously dominated since the Depression, and similar long waves have been picked by many others since Kondratiev (1925).

Kaplinsky (2005) makes a comparison between the late 19th and early 20th century period of internationalisation on the one hand, and on the other hand the period of globalisation starting in the late 20th century. He comments on the different mix of goods traded, and on the different migration patterns – of the poor in the earlier phase and the skilled and a greater proportion of the monied in the latter.⁶

He also points out⁷ that there is a high correlation between effective financial intermediation and economic growth, but that excessive volatility can reduce growth. Hence policymakers often want the competition, ideas and capital which come with openness but are concerned about volatility. Although portfolio investors are not necessarily short term in their outlook, some policymakers – not liking potential volatility in their exchange rate driven by short-term changes in cross-border portfolio flows – are attracted to the idea of discouraging portfolio flows through taxing capital inflows rather than trying to attract more long-term stable investors. Yet trying to prevent inflows rarely has more than a temporary impact on the exchange rate; given inevitable efforts to bypass the restrictions, it can encourage speculative pools of capital and discourage longer-term flows. Hence the simple mantra that characterises portfolio flows as speculative and thus undesirable may be misplaced. Indeed, efforts to restrict such flows can result in more not less volatility.⁸

1.2.1 The desire to control and its impact on trade

Why do simple policy measures to reduce volatility so often backfire? Today’s environment is one of economic complexity, economic liberty and freedom of thought and action. There is a lot of uncontrolled international movement of goods and capital, whereas in the pre-industrial past the movement that did exist was smaller and simpler. The state may have become less able to impose direct control on the mass of individuals and firms, but many have also become more sophisticated at indirect control and at exploiting the behaviour of firms. As Lucas (1976) pointed out in the so-called ‘Lucas critique’, the use of aggregate macroeconomic data to predict the effect of policy changes can be frustrated. This is due to the behaviour captured by such aggregate data not being independent from policy, but affected in complex ways.

Political control in many spheres has changed. It has been decentralised in some cases as smaller groups have asserted themselves and the centre become less powerful, such as during the fall of Rome in the 4th century, but also due to deliberate delegation of responsibility downwards. In other spheres power has centralised, and many of the problems faced by policymakers today require action above the level of the nation-state to be effective, including some aspects of anti-terrorism and environmental policy. As people’s identities and loyalties have multiplied and become more complex and global, identification with the state has also changed, and the degree to which countries can co-opt their citizens in certain ways.

But democracy and well-being are both probably strengthened by this greater complexity. The multiplication of special interests, competing with each other, reaches a point beyond which any central source of political power can command a majority of support whatever mix of policies is chosen. Democratic institutional forms constitute instead legitimising filter mechanisms, the function of which is not merely to create compromises between political groupings but also to allow all politically active groups and ind...

Table of contents

• Cover
• Half Title page
• Dedication
• Title page
• Copyright page
• Foreword by Nigel Lawson
• Acknowledgements
• Introduction
• Chapter 1: Globalisation and the Current Global Economy
• Chapter 2: Defining Emerging Markets
• Chapter 3: The 2008 Credit Crunch and Aftermath
• Chapter 4: Limitations of Economics and Finance Theory
• Chapter 5: What is Risk?
• Chapter 6: Core/Periphery Disease
• Chapter 7: The Structure of Investment
• Chapter 8: Asset Allocation
• Chapter 9: Thinking Strategically in the Investment Process
• Chapter 10: A New Way to Invest
• Chapter 11: Regulation and Policy Lessons
• Chapter 12: Conclusion
• Further Research
• Disclaimer
• Glossary
• Bibliography
• Index