Looking beyond the crisis : a world of BRICs

The US financial crisis that started in July 2007 with the collapse of two Bear Sterns subprime hedge funds has now turned into a full-blown global economic crisis. Arguably, the climax of the financial crisis has been reached with the collapse of Lehman Brothers on September 15, and the subsequent fall of stock markets all around the world.

Since then, governments have been hastily working out massive bailout plans for their banking systems, in the United States, the European Union, Russia, South Korea, and elsewhere. This was a long awaited recognition that radical measures were needed to avoid a global collapse given the huge amount of outstanding derivatives and other off-the-balance-sheet liabilities threatening the stability of the global financial system.

Despite this massive effort, it is clear that the large developed economies will undergo one of the most difficult periods since many decades. The deleveraging process will be long and painful because the liquidity crisis has translated in a permanent increase in the cost of capital which makes the current downturn much more pronounced than previous ones.

It is also clear that some medium-sized emerging economies such as Hungary, Turkey or Ukraine, that relied heavily on foreign capital to fuel their domestic growth are feeling the heat as foreign investors start to repatriate capital to safer places. Hungary and Ukraine are in the process of being bailed-out by the IMF and will have to sacrifice growth for some years. Turkey has also seen large outflows of capital, but it is in a better shape now than at the start of the decade when the country had to devalue its currency and drastically restructure its economy.

The key question however is the impact of the crisis on the "trillion plus" emerging economies of China, India, Brazil, Russia, Mexico, and Korea, and the extent to which it could jeopardize their long term growth potential.

In this regard, China and India have been relatively spared thanks to their lack of financial integration with the world. By contrast, there are sobering news coming from Russia, Mexico and Brazil, where healthy companies now struggle to roll over debt due to foreign investors. As a matter of fact, in the past few weeks the yield on corporate bonds of leading Mexican companies such as Cemex and Telmex have skyrocketted. Mexican and Brazilian companies are facing billions of losses because of the sharp depreciation of their domestic currencies against the US dollar. Finally, Russian oligarchs are desperately asking and getting - at a heavy price - the support of the Kremlin to pay back foreign creditors who threatened to seize large shares of Russian companies, which were pledged as a collateral for loans.

Nevertheless, the situation is in no way comparable to the nineties where one big emerging country defaulted after the other. The liquidity problems faced today by Russian, Brazilian, or Mexican companies are much more manageable than the solvency problems faced by their governments a decade ago. With huge foreign exchange reserves of over half a trillion US dollars, Russia has made it clear that it can deal with the crisis without external help. Mexico, Brazil, and South Korea, also have reasonable foreign exchange reserves. Besides, they are supported by the Federal Reserve which has commited USD 50 billions to each of these countries in currency swap agreements, as a recognition of their "systemic importance". In addition, all these countries have actioned comprehensive bailout plans for their financial sectors and for their blue chip companies through state-guaranteed liquidity lines, injections of capital, tax exemptions and the like.

Most importantly, when the dust will settle down, and the world economy will gradually recover from the crisis, the new expansion cycle will be, by all accounts, dominated by the BRIC economies. China will get out almost unaffected by the crisis. The likely slowdown of the chinese economy in 2009 will probably be very moderate because it will be cushioned by the massive spending plan announced by the Government to boost the construction sector and support falling house prices. The slowdown will result in a much welcome consolidation across a wide spectrum of industries ranging from mining, power generation, automotive, and white label manufacturing, to real estate development and financial services.

In a year or two from now, Chinese large banks and manufacturing companies backed by the state could take over some iconic brandnames in the western world. Take the automotive industry. While the "big three" US carmakers, GM, Chrysler and Ford are on the brink of bankruptcy, the booming Chinese car industry is moving forward thanks to a rapidly growing domestic market and to the ever improving quality of local brands which benefited from partnerships with western carmakers. The Obama administration will likely wellcome any foreign investments in this distressed sector rather than running the risk of losing hundreds of thousands of jobs. No doubt, China has the will and the financial resources to become a superpower, but it still has to transform itself and achieve its democratic transition, under the pressure of a growing urban middle class.

The Russian economy will escape a 1998 style collapse and consolidate its influence in regional and world affairs as a global supplier of energy and military technology. No matter how untrustful Russia's political elites may appear to the West, there is no choice but to cooperate with them and include them in the game, in order to concentrate on the weak spot of the planet, namely the Middle East. On the other hand, Russia's renaissance as a global power is far from granted, as it will depend critically on the government's ability to move to a knowledge based economy from its current over reliance on natural resources.

Finally, among the BRIC countries, India and Brazil are probably going to make the most important breakthrough in the coming years. They have unleashed their growth potential only in the nineties (in 1991 for India and 1994 for Brazil) and much of their growth acceleration still lies ahead. Contrary to China and Russia, India and Brazil will continue to benefit from the "demographic dividend" with a growing working-age population.

Brazil is not only one of the world's biggest and most diversified commodity producers, it is also becoming a major competitor in high-end technologies, with a competitive edge in cleantechs and renewable energies. Brazil's most accute problem, the low average level of education of its 190 million population is being addressed by comprehensive social programs such as Bolsa Familia which encourages poor families to send their children to school. As a result the gap between the poor and the rich, deemed to be the highest in the world, will gradually narrow in the next decade, paving the way for a growth potential closer to the 10% magical threshold.

Last but not least, India, the world's largest democracy, has recently decided to tackle the infrastructure problem with a massive investment program over the next 20 years. It has set up one of the most investor-friendly PPP legislation and is attracting foreign capital from all over the world to help it, litterally, bridge the gap. Education is still a daunting issue for hundreds of millions of peasants relinquishly kept out of the "shining India" picture. However, the liberalization of the economy has unleashed the energy of millions of entrepreneurs and has considerably improved social mobility, leading to a widening of the middle class. There are opportunities in almost every sector and the so-called "licence raj" has substantially decreased over the last years. True, India has still a long way to go before it joins the club of advanced nations, but it already has serious credentials in information sciences, nuclear engineering or space technology.

All in all, retreating now from emerging markets, and from the BRIC countries in particular, although seeming rational in an environment of high risk aversion and liquidity dearth, would be a serious mistake in the long run, given the almost intact growth potential of these economies and given their importance in shaping tomorrow's world, far beyond the current crisis.

The outlook for China's big four banks

The Empire state building dressed up in red and yellow to celebrate the official opening of ICBC's branch in New York on October 15, 2008

Record profits for Chinese banks

China's "big four" commercial banks have posted record profits in H1 08 reflecting the resilience of the Chinese economy which grew by 10.4% in the first half of the year. َ

As a matter of fact, the operating profit of Industrial and Construction Bank of China (ICBC, HKG:1398), China Construction Bank (CCB, HKG:0939), Bank of China (BOC, HKG:3988) and Bank of Communications (BOCOM, HKG:3328) grew on average by 35% in H1 08 from the same period a year ago. After-tax profit jumped on average by 62% , BOCOM leading the way with an 81% increase and BOC lagging behind with a mere 38% . In addition, the return on equity of the four largest chinese commercial banks reached a stunning 23% up from 19% a year ago.

With an after-tax profit of RMB 64.9 billion yuan ($9.57 billion) in H1 08, ICBC, which is already the bank with the biggest market capitalization in the world, became the world's most profitable bank, largely ahead of follower HSBC which posted a profit of $7,7 billion.

At a time when the United States face their worst financial crisis since the Great Depression, these figures signal a shift of financial power to China and reward the prudent policies put in place by the Chinese authorities over the last expansion cycle to reign in credit and avoid the accumulation of bad loans that clogged the banking system in the late nineties.

In a context of increased competition from both domestic and foreign players, China's "big four" banks have achieved a dramatic transformation over the last five years moving from an administrative culture to a customer-centered culture, extensively diversifying their offering of products and services, and opening up their capital to global financial institutions such as Citigroup, HSBC, and Bank of America.

Preparing for the downturn

Ironically the exceptionnal H1 profit figures have been permitted to a large extent by the PBOC's six consecutive hikes of interest rates in 2007/2008 which boosted the commercial banks interest margin, before the central bank reversed its policy in September, amid growing concerns over the economy. In fact, interest income still contributes between 75% and 85% to the operating profit of the big four, although the contribution of net fee and commission income has steadily increased over the last few years. If the PBOC lowers by 100 bp its benchmark rate in the coming months, this could cut off roughly 20% to 30% of the banks operating income.

In addition, the fee and commission income comes in part from wealth management services can be significantly impaired if the stock market does not stabilize in the coming months.

Finally, although there should be no hard landing of the chinese economy in 2009 if domestic demand remains strong enough to compensate for reduced external demand, any slowdown will impact heavily the most exposed sectors of the economy : small private export firms mostly based in the Pearl River delta, and property developers which will be hurt by the falling property prices in some of the country's major urban hubs (Shenzen, Shanghai, Hanzhou,...). Hence, credit losses are likely to rise over the next few quarters, therefore negatively impacting the commercial banks operating income.

All in all, H2 profits figures are likely to bring more sobering news than the skyrocketing H1 figures. However, with an average capital adequacy ratio of 13, with a geographically diversified business across all the major provinces of China, with a stable funding made up mostly of corporate and individual deposits, the Big Four are relatively well prepared for the downturn. Besides, the valuation of their shares is now exceptionnally attractive given their high return on assets, their low cost-to-income ratio (around 35%) and their long term growth potential.

Bottom line : if you want to make a bet on China's long term growth story then make a bet on China's big four banks !

An insider's view on emerging markets

I recommend this interview of indian private equity fund manager, Mr. Partha Gandhi, managing director of Vision Investments, published today by The Economic Times. Here are some excerpts from this interview. Mr. Gandhi conforts our long secular view on emerging equities while aknowledging that there could be still a lot of volatility and downside pressure in the next 6 to 12 months.

With the liquidity crunch accelerating, how do you map the emerging market universe in the next 3-6 months?

If there is a slowdown in the US, you are going to see a fallout across every major country in the world. If you go back and look at some of the financial crises that you have had over the past century, there are quite a few. If you start mapping these out, this is one of the worst we have seen in a long, long time. In the emerging market universe, markets like India, Brazil or China are showing signs of decline. Markets are typically going to look to future and based on that, there will be issues. ICICI Bank is a case in point.

They have issued a statement saying they have not been affected in a big way, and I tend to agree. You will find that Indian banks have some exposure, but not tremendous exposure. We are looking at tough times ahead, at least for the next 6 months.

I believe that the entire emerging market sector, whether China or India, is going to start looking better around June next year. By which time, you will see more clarity, more visibility in the market. What I would look for in emerging markets is equities, where one can find quality through strong fundamentals and good cash flow.

(...)

What is your sense of where the Indian market is headed and how do we compare vis-à-vis other emerging markets now?

Indian markets have been hit by the recent global shakeout, but not as badly as others. That’s primarily because we have a strong domestic internal market. We are looking at global pressure, but the internal consumption story is very strong.

If you look at liquidity, we have a relatively well-regulated banking environment. In fact, it is the regulatory environment that has served as a cushion for India. We could have been completely open and in a lot more trouble.

That said, hedge funds have a lot of performance pressure compared to, say, private equity funds which can afford to take a 5-year view. So, short-term performance is a tough call right now.

Why this could be the right time to buy emerging markets equities

In these times of high volatility and risk aversion, some people may find it foolish to buy emerging equities which are traditionnally considered as "high beta" risky investments.

It may seem a bit contrarian indeed, but I am not the only one to hold this view. Seasoned investors like Mark Moebius who manages 34 billions USD of assets at Templeton Asset Management are more bullish than ever on emerging markets (see video above).

Emerging markets have performed poorly this year

So far, it is true that emerging markets have suffered more than developed markets from the general flight to safety away from risky assets. As a matter of fact, on a year-to-date basis, the iShares MSCI Emerging markets ETF index (NYSE:EEM) dropped a whopping 39% compared with a drop of "only" 25% for the iShares S&P 500 ETF Index (NYSE:IVV) !

In addition, there is now a widespread feeling that the worst is yet to come for the global economy, as economic data clearly shows the United States, Europe and Japan have either entered into recession or are on the brink of it.

As investors around the world try to find out where are the next victims of the global credit crunch, one big question mark lies on the so-called BRIC countries (Brazil, Russia, India, China) which have alltoghether accounted for two thirds of global growth over the last five years (on a PPP basis).

So, is it just a matter of time before these economies falter and fall into recession ? For me, the answer is NO.

Why emerging economies will not fall into recession

With all the gloom and doom coming from Wall Street it is very difficult to keep one's nerves. If stock markets were a good predictor of developments in the real economy than we should really worry, as stock markets in the BRIC countries lost between 40% and 50% of their market capitalization in just a few months.

Actually, stock markets are NOT a good predictor of the real economy as far as emerging markets are concerned. At short time horizons, these markets are in fact much more influenced by the US stock market than by developments in their domestic economy. Call it financial integration or call it contagion it does not matter. This owes simply to the hegemonic nature of the United States which still account for 26% of the world GDP and 34% of the world market capitalization as of september 2008 (down from more than 50% five years ago).

The true story is that of a gradual decoupling between developed and emerging economies. The former are now going through a painful deleveraging cycle after having lived for many years"beyond their means". In sharp constrast, the latter are witnessing an unprecedented boom with domestic demand soaring thanks to massive investments in infrastructure, a construction boom, and an incredible consumption frenzy .

Don't mistake me, I am not saying that everything is rosy for emerging markets. Many export-led emerging economies will be impacted in a way or another by a recession in the developed countries. However, this impact should be cushioned by the growing South-South trade between emerging countries themselves. Hence, Russia and Brazil will continue to import manufacturing goods from Сhina and India which will in turn continue to buy commodities from the former to satisfy their huge thirst for energy and basic resources.

Some good reasons for investing now in emerging markets

Although the earning prospects of some companies based in emerging markets may be negatively impacted in the short term by slowing orders from the US and Europe, this provides them with an incentive to increase their productivity and to move up the value scale. As an example, Wen Jiabao, the Chinese Premier urged last week chinese manufacturing companies to invest more in innovation and to export more products under their own name, rather than just being low cost contractors for western companies. The same is happening in India, as the battle for Axon illustrates it, with indian outsourcing companies increasingly looking to expand beyond their borders, and to deliver high value-added services.

Another good reason for being bullish on emerging countries comes from the fact that they have been relatively well preserved from the global credit crunch. Indeed, most emerging economies are awash with cash, with large foreign exchange reserves and well capitalized banks which have developed overstretched investment banking departments, and have not invested in the kind of toxic securities that brought down to its knees the entire US financial system.

Finally, if you look at equity valuations, given the tremendous growth potential of these economies that still lies ahead, the current valuation of hundreds of blue chips companies from Turkey, Russia, China, or Brazil have never looked as attractive as now ! And although the MSCI Emerging Markets is down 39% this year it is still up by more than 93% from its level five years ago !

For all these reasons, this is the right moment to buy excellent assets at bargain prices, with the intention of holding them for 5 to 10 years.

Alex Kateb

This article has been published on Seeking Alpha, a leading investment website, at the URL http://seekingalpha.com/article/98662-why-now-could-be-the-right-time-to-buy-emerging-markets-equities

The battle for AXON and its implications for the Indian I.T. sector

As Ramit GUHA writes in the WSJ, the battle is raging between Indian firms INFOSYS (BOM:500209) and HCL (BOM:532281) for the takeover of AXON Group (LON:AXO), a British I.T. software company with strong value-added SAP implementation capabilities and with a foothold in the UK and in continental Europe.

This battle epitomizes the new creed among indian I.T. outsourcing companies as they try to diversify their clients base away from the ailing US market (that still represents 60% of their overseas turnover with the bulk in financial services), and as they seek to move up the value scale, away from low margin outsourcing into high margin I.T.consulting services.

So far, indian outsourcing companies like INFOSYS, WIPRO, TCL, and HCL have done relatively well both in terms of revenue generation and margin expansion, with INFOSYS being unchallenged as the industry leader both in terms of revenue growth and profitability.

But the financial meltdown in the United States is forcing Indian outsourcing companies to reinvent themselves if they want to survive. As a matter of fact, wage inflation in India has reached double digit levels this year putting a strong pressure on costs amid a shortage of skilled labour, and international competition has increased in the low end of the business from сountries such as Vietnam, Ukraine, and the Philippines.

If as we expect, the cash-rich INFOSYS succeeds in this takover battle over AXON, it will strenghten its revenue generation potential and preserve its advantage over its local and international competitors. However, it will take more time and more substantial acquisitions for INFOSYS to compete with global consulting giants such as IBM and ACCENTURE.

In this regard, the dismissed rumour that had been circulating a year ago about a potential acquisition of Paris-based CAPGEMINI, a heavyweight in the European I.T. consulting industry with a workforce of 75000 equivalent in number to that of INFOSYS, looked much more like the perfect strategic move for the Indian company ! But at that time CAPGEMINI was probably considered "too big to swallow" by the Bangalore-based conservative management. Watch out for further developments this year !

Alex Kateb

This article was also published on Seeking Alpha, the leading provider of stock market opinion and analysis, at the following URL http://seekingalpha.com/article/98193-implications-of-the-battle-for-axon-for-the-indian-it-sector