Emerging Markets: A Case Study

Until 1982, financiers called the world's poorest countries 'lesser developed countries,' or LDCs. Lending to their governments was all the rage. One year, and one epic financial crisis later, the LDCs had been re-branded 'emerging markets' and investors grew keen to put money into company stocks. This re-branding enriched many, pulled others out of poverty and helped create the conditions for the global crisis of 2008.

During the LDC boom José López Portillo, then President of Mexico, told his people to "learn how to administer abundance" as he poured money into the oil industry. LDC investing was driven by commodity prices, emerging market governments and western banks. High oil prices were creating greater wealth. Western banks needed new sources of business because capital markets were stripping them of many of their traditional businesses. And Third World governments – Mexico above all – wanted to borrow.

High oil prices warped perceptions the world over. The oil price spikes of the 1970s had left the big oil-producing nations with surplus funds, generally labelled petro-dollars, which they deposited with western banks. The banks then had to find something to do with them. Just as in 2008, they proved irresponsible in the way they dealt with it.

LDCs gave the petro-dollars a natural home. Money poured into Latin America, and particularly Mexico. At the end of 1970, Latin America owed a total of $29bn. By 1982, the region's indebtedness hit $327bn. Banks clubbed to make the loans, which had a variable interest rate, and were denominated in dollars, meaning repayments could rise sharply if a country's currency devalued. But they were not too worried because, in the words of Walter Wriston, the Citicorp chief executive of the time, "The country does not go bankrupt. Any country, no matter how badly off, will 'own' more than it 'owes'".

But sometimes, countries do go bust, and the circumstances that led Mexico and the American banks into each other's arms in the first place also bore the seeds of eventual disaster. The money ignited an unsustainable boom in Mexico, where inflation took hold. Meanwhile, higher rates and lower inflation in the US under the strict rule of Paul Volcker at the Federal Reserve pushed up the value of the dollar, and with it the cost for Mexicans of servicing their debt. Lopez Portillo vowed to defend the peso "like a dog" but in the summer of 1982, he had no choice but to devalue. That meant disaster for the banks' loans, which deepened when the president nationalised all of Mexico's banks.

Where Mexico led, others followed. By October 1983, 27 countries were rescheduling their debt, and the region set in to what is now known as the "lost decade". Meanwhile, a Mexican currency crisis metastasised into a US banking crisis. Mexico, Brazil, Venezuela and Argentina owed $37bn to the eight largest banks in the US between them - almost 50%more than those banks held in capital and reserves at the time. These crises took the best part of a decade to resolve, as countries renegotiated loans, while American regulators let the banks limp along on life support, rather than forcing them to recognise all their losses – lenient treatment that arguably encouraged greater risk-taking for the future.

Markets already suffered the pathology that led to disaster in 2008. US banks behaved irresponsibly. Problems for the poor (Latin America) soon turned into problems for the wealthy (big US banks). High commodity prices blurred judgments, and drove excessive flows of money into small markets, thus destabilising them. Driving everything were the international price of oil, and the state of the US credit market.

This was for the future. In 1982, the World Bank had a more immediate problem: how to finance the Third World? Lending to them was dangerous for lenders, and the countries themselves badly needed to reduce their reliance on debt, so the critical need was to persuade investors to buy the equity of growing companies. If things went well, there was more "upside" for investors. And if they did not, it is far easier to skip a dividend payment than to default on a loan.

But the job of vetting and valuing companies in countries like Brazil or South Korea was prohibitively expensive. Political, cultural and language barriers were immense, and local courts could not be relied on if the worst came to the worst. There might be opportunities for growth in the Third World, but it was not worthwhile for fund managers in the west to search them out. And after 1982, nobody wanted to invest in Less Developed Countries.

The answer, pioneered by a young Belgian World Bank official called Antoine van Agtmael, was to set up a fund. He and his colleagues would do the hard work, and investors would have a shot at big gains. Portfolio diversification would help. Invest in many countries, and the damage from political or legal upheaval in any one of them grew that much less. He proposed to call this the Third World Equity Fund.

His colleagues told him this was a terrible name. And immediately, says van Agtmael, "a light bulb went off in my brain. Who wants to invest in the Third World? They weren't even second-rate; they were third-rate. That's when I came up with 'emerging markets' which I felt had a little more pizzazz." While Third World suggested stagnation, "emerging markets" suggested "progress, uplift and dynamism". He wanted, in short, to rebrand a large swathe of the world, and to create a new class of assets for investors to invest in. And he succeeded.

The idea worked, and other investors soon launched their own funds. Their job became easier, and the definition of "emerging market" grew clearer, after Morgan Stanley Capital International (MSCI) started its emerging markets index in 1988. This gave managers an index to group around and, like other indices, it soon outgrew its status as a passive benchmark to become an active guide to their investing.

It proved mighty profitable. The MSCI index started on New Year's Day 1988 at 100. By November 1994, it stood at 563 – staggering growth that attracted money from all sides. Its correlation with the MSCI World index, covering the world's developed markets, was minimal, and sometimes even negative, suggesting that emerging markets provided a true hedge against events elsewhere in the world.

Financial engineering drove lasting changes in the real economy. As more investors bought in, so their money drove outcomes. If investors felt optimistic, then emerging markets allowed them to take more risk, with the chance of bigger returns. If they were pessimistic, risky emerging markets stocks were the first they sold. Over time, MSCI's emerging markets index correlated ever more closely with the developed world. Far from providing a hedge, by 2009 as much as 80% of its daily movements could be explained by changes in the World index. Investors could easily expose themselves to the volatility of emerging markets. But it was perhaps more concerning that those emerging markets were now exposed to the volatile behaviour of western investors.

As for President Lopez Portillo, who had fallen and risen with the LDC boom, and promised to defend the peso like a dog, he lived out his days in disgrace. Whenever he entered a restaurant, the other diners would bark at him.