Massive investment to shield emerging markets: James Saft

(James Saft is a Reuters columnist. The opinions expressed are his own)

By James Saft

LONDON (Reuters) - It probably won't be pretty and it certainly will be volatile, but massive investment in infrastructure and the absence of a debt bubble will allow emerging markets to fare better even as the developed world struggles.

Emerging markets have had a bad start to the year, hurt by a growing fear that a recession in the United States would, as it historically has, hit them harder, dashing hopes for a "decoupling".

The MSCI Emerging Markets index has fallen 12 percent, more than the main developed markets index, and investment in emerging market debt is showing a loss for the year.

But an historic program of urbanization in emerging markets - and all that entails; power, transport and a growing service sector - is highly unlikely to be derailed and will provide huge stimulus to offset falls in exports.

Fixed investment, such as in roads, rail, utilities and buildings, rose by 27 percent in China and India last year, according to Nomura International, and at a combined $2.2 trillion is poised to exceed that of the United States in the next two years.

"What it means is that emerging markets will probably decouple more than most people believe," said Shanat Patel, global emerging market strategist at Nomura in London.

"Exports are much smaller than fixed asset spending but people think an export-led slowdown will slow fixed asset spending quite sharply. That would be the tail wagging the dog."

Patel points out that in places like South Africa and India infrastructure projects, particularly in power, are needed to cover shortages, rather than just to meet anticipated growth, making them far less likely to be shelved.

And too, the move to the cities seems unstoppable. Take for example China, where 44 percent of people live in cities, up from 36 percent in 2000 and compared to over 80 percent in the United States and Britain, according to United Nations data.

Besides all the building that growth implies, city dwellers generally consume a lot more than their country cousins, and differently. For one thing, they use many more services, providing a counterbalance to manufacturing and exports.

To be clear, this is not to say that emerging markets are immune to global economic trends. A fall in trade with rich nations will hurt. And when investors take big hits in their developed world holdings, they will tend to sell their emerging markets stocks and bonds too.

RAILROADS VS GRANITE COUNTERTOPS

So, if we accept that the United States will have a recession and Europe and Japan suffer too, what would that mean for emerging markets?

It would certainly hit exports. Credit Suisse global strategist Andrew Garthwaite estimates that a one percent fall in developed market growth would shave Chinese export growth by 3 percent and GDP growth by 1.3 percent. China recently reported 2007 GDP growth of 11.2 percent, so such a hit would not be the end of the world.

Exports within emerging markets have also risen, to 49 percent of overall exports from 42 percent a decade ago.

"Critically, we find global emerging market exports to other global emerging markets have been resilient as retail sales growth in both Asia and Latam have held up because: real rates are low, savings ratios are high and leverage is low," Garthwaite wrote in a note to clients.

The leverage and savings issues are especially important. The developed world, especially the United States, is coming off a debt binge that artificially boosted growth, profits and asset values. Banks are having a tough time playing their part in a recovery because their losses are too big in proportion to their capital, while consumers are vulnerable because they've borrowed too much and saved too little.

It is all pretty much the reverse in emerging markets. The ratio of debt to equity at emerging market companies, including banks, is 35 percent, as opposed to 156 percent in the developed world, according to Nomura data, while savings are high.

"Most of the return on equity in developed markets in recent years came from gearing," said Patel.

Profit growth in emerging markets has largely come from improvements in profit margins, he said.

Put it this way - a lot of growth in the United States recently came from investment in things like real estate, which is now going down in value, or in marble countertops in expensive kitchens, which in the current context seem, shall we say, extravagant.

In contrast, Morgan Stanley sees $300 billion of investment in emerging market railroads over the next five years.

Let's see, emerging markets have money and need investment, while developed markets have banking problems and have misallocated resources.

So, where would you put your money, marble countertops or railroads?

(At the time of publication James Saft did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund.)

(Editing by Stephen Nisbet)