Eastern Europe and Turkey: BRIC Wannabes (2008-09-22)

Eastern Europe and Turkey: BRIC Wannabes

(2008-09-22) by David John Marotta

In 2003, the Goldman Sachs Global Economics Department predicted that the economic and geopolitical influence of Brazil, Russia, India and China (the BRIC countries) would become increasingly visible in the developed world and even dominate it by 2050.

BRIC nations have surpassed expectations. The original Goldman Sachs analysis projected the four economies would comprise over 10% of the global output by the end of the decade. A year and a half early, they comprise nearly 13%.

Goldman Sachs published an update on the BRIC nations this year, forecasting that although growth is slowing, they will still contribute almost half of all global growth in 2008 and 2009.

It is easy to be lulled into thinking you can simply buy and hold investments in BRIC countries. But emerging markets have faced serious crises every several years. A better strategy is to buy and rebalance, trimming positions as they appreciate and reinvesting as they correct. With the drop in emerging markets this year, 2008 is now an opportunity to reinvest.

These countries have averaged a total return on investment in their stock markets that is now down to 27.49% over the past five years because they have dropped sharply over the past year, falling 24.48%.

The BRIC acronym made four emerging market countries sound like more attractive investment opportunities than the other two dozen. Nobody likes being excluded from the cool crowd. Other countries have been clamoring to add their initials into the mix ever since.

BRICET is the term used to add Eastern Europe and Turkey to the in-crowd. Since the fall of the Soviet Union, Eastern European countries have been struggling out of the darkness of communist rule into the light of free markets.

Eastern Europe has become a fuzzy term that may include a different set of countries depending on who is using the label.

The S&P/Citigroup BMI European Emerging Markets Capped Index includes companies from the Czech Republic, Hungary, Poland, Russia and Turkey. This index, constituted to include the most developed countries of Eastern Europe, is heavily weighted toward Russian companies as a result. Selecting these countries produces an index that is more developed than the typical Eastern European country.

The least developed countries are sometimes not even classified as emerging. Instead they are labeled "frontier markets," a step below emerging. These countries include Albania, Belarus, Bosnia, Bulgaria, Croatia, Estonia, Herzegovina, Latvia, Lithuania, Montenegro, Republic of Macedonia, Romania, Serbia and Ukraine. Many of them are listed in the MSCI Frontier Markets Index.

Although a few of the countries just named, such as Ukraine and Croatia, have very little freedom, others are entering the global scene on the side of free markets. A dozen countries in Eastern Europe have implemented a flat tax on either personal or corporate income. Most of them have a higher percentage of freedom than even Brazil, the best of the BRIC countries, according to the Heritage Foundation's Freedom Index.

In addition to a flat tax, many Eastern European countries are taking advantage of their proximity to Western Europe. Several Eastern European countries have joined the European Union (EU) and benefited from the single economic market representing 31% of the world's total economic output. The lack of trade barriers and a common stable currency encourages growth. To join the EU, a country must have a stable democracy that respects human rights; the rule of law, including EU law; and a functioning market economy capable of competing within the EU.

These requirements have the effect of pushing countries politically toward free markets, which helps them overcome the socialist or centralized planning legacy of communism. In addition to economic alliances with the West, some have also been invited and joined NATO. Turkey also enjoys significant freedom having been a part of NATO since 1952.

All of these economic freedoms and the accompanying social stability have produced good investment returns for Eastern Europe over the past five years, averaging 20.51%. The MSCI Turkey Index averaged 25.20% over the past five years. The BRIC index has earned 27.49% annualized.

But all emerging market countries have a high correlation. Little benefit is gained by diversifying among BRIC, Eastern Europe and Turkey. Currently the BRIC index is down 38.86% year to date. Eastern Europe is down 39.16%, and Turkey is down 31.30%.

Emerging and frontier markets are suitable for a portion of your portfolio, but only a portion. You must take care to limit the percentage of your assets invested in categories that are highly correlated and therefore all move in sync with one another. Diversification means finding asset classes that are not positively correlated to reduce the chances that everything in your portfolio goes down together.

Determining the correlation between your investments is one of the most important steps you can take toward building a defensive investment strategy. Tools are readily available online. Or to find a fee-only advisor in your area, visit the National Association of Personal Financial Advisors at www.napfa.org.

from http://www.emarotta.com/article.php?ID=302

BRIC Countries: China (2008-09-15)

BRIC Countries: China

(2008-09-15) by David John Marotta

In mid-September, the Chinese observe the Moon Festival. Timed to the moon's fullest and brightest phase, the festival celebrates the abundance of the summer's harvest. In recent years the Chinese economy has been waxing toward ascendance. It passed Japan in November 2007 and began to rival the brightness of America.

One in every five people in the world lives in communist China. Unlike other BRIC countries, the Chinese lack representative government, the rule of law administered by independent judges, basic human rights, freedom of the media, independent universities and the right of workers to move freely. Even the constitution makes clear that the government has no limits or accountability to the Chinese people.

China began its experiment of mixing explosive free-market economics with totalitarian control and repression in 1978 when Deng Xiaoping took power.

After having been purged once by Mao and a second time by the Gang of Four, Deng did not deify Mao. Rather he declared the leader to be "seven parts good, three parts bad." Understanding that Chinese Marxism needed to be reinterpreted to allow market forces, Deng argued that "socialism does not mean shared poverty." His most famous quote clarifies his utilitarian nature: "I don't care if it's a white cat or a black cat. It's a good cat so long as it catches mice."

Deng abandoned centralized planning and protected the unrestricted flow of goods throughout the country. The resulting competition between provinces led to significant growth in China's standard of living. Unlike Gorbachev, who tried to institute his own reforms in the top-down approach of perestroika, Deng simply allowed freedom at the bottom. Then he sanctioned and took credit for whatever reforms worked.

Much of China's innovation has been an investment in infrastructure. The country is spending about 12% of its gross domestic product (GDP) on infrastructure, which accounts for 43% of emerging market investments. Greater investment in infrastructure reduces the cost of moving goods and allows freer trade within the country. Estimates suggest that a 1% increase in a country's infrastructure boosts its GDP by 1%.

So the resulting economic growth in China has been explosive. But containing an explosion is difficult if not impossible.

Free markets thrive when a country guarantees property rights and the rule of law. China possesses neither of these. All land is state owned and can only be leased. The state also owns the banks, either directly or indirectly. A majority of judges are retired military officers and directed by the party. As a result, enforcement of contracts is impossible. Party officials are effectively police, prosecutor, judge and jury for any case of importance.

Currently China is ranked 52.8% free, "mostly unfree," in the Heritage Foundation's Index of Economic Freedom. Although it ranks 126 out of 157 countries, China does place highest among the communist countries, beating Vietnam, Laos, Cuba and North Korea.

Freeing selective market forces produces impressive economic gains until bottlenecks in the existing monuments to centralized power hinder progress. Without a free press and working court system, the resulting internal totalitarian monopoly of economics can't be called capitalism. As a result, most of China's growth stems from its participation in free-trade agreements.

Thanks to China's growth, it will pass the U.S. economy in the near future. But because of its huge population, its average citizens will still be economically poor by American standards. And they will be politically destitute.

The Communist Party in China worries most about religious movements, which pose the greatest threat to the party's supremacy. In 1999, about 10,000 members of the Falun Gong spiritual movement surrounded the Chinese Communist Party headquarters in Beijing. They silently meditated to protest their rejection as an accepted spiritual movement. As a result, China severely repressed Falun Gong's leaders and practitioners.

Religious groups are obligated to register in China. Their leaders must be trained and approved by the government. Sermons and teachings are monitored to ensure they do not confront government decree. Thus spiritual movements such as the Falun Gong and unregistered house church movements provide the biggest challenge to the party's supremacy and power.

Movement toward democracy, freedom and the rule of law is not inevitable. Since the brutal crackdown on pro-democracy demonstrations in Tiananmen Square in 1989, government leaders have used force to remind the population of their control. China has its own gulag where labor camps reeducate, terrorize and torture. According to Amnesty International, human rights violations are pervasive in China where nearly half a million people currently endure punitive detention without charge or trial.

Although movement toward freedom is not inevitable, the yearning for freedom is universal.

China exemplifies how the free flow of information allows a developing nation to leverage other countries' knowledge and double its per capita GDP in a decade or less. And yet China fears this freedom. It is nearly impossible to stop the flow of information, but the government continues to try. Dubbed the "Great Firewall of China," over 60 sets of broad regulations restrict Internet content.

The returns on investments in China have been impressive, averaging 23.8% over the past five years. Despite these returns, we don't recommend selecting China for specific emphasis. It is a component of the Emerging Market Index, which should be a small part of your portfolio. Think twice before investing in China because investments there won't always go up. In fact, over the past year China's return has been down 26.1%.

But you don't need to invest directly in China to benefit from a growing Chinese appetite for goods and services. Several countries in the Far East both engage in significant trade with China and also offer exceptionally open markets. Among economically free countries in the region, Hong Kong at 42.6% reports the highest percentage of its exports with China. Australia is also significant at 8.4% of its exports. Even "mostly free" Taiwan (14.9%) or Japan (12.2%) would be preferable to direct investments in China.

from http://www.emarotta.com/article.php?ID=301

BRIC Countries: A Passage to Indian Freedom (2008-09-08)

BRIC Countries: A Passage to Indian Freedom

(2008-09-08) by David John Marotta

The modern-day Indian republic was born in 1950. During the cold war between the United States and the Soviet Union, India was a prominent nonaligned country. It was highly socialistic with the government exercising control over every aspect of the economy. These restrictive policies caused extremely low growth rates, derisively dubbed the "Hindu rate of growth."

Not until the late 1980s, when facing deficits and a major balance-of-payment crisis, did Prime Minister Rajiv Gandhi attempt to remove price controls and reduce corporate taxes. Growth increased, but partial freedom just moves economic bottlenecks to the next malfunction of Fabian socialism.

Finally in 1991, Prime Minister Narasimha Rao, along with Finance Minister Manmohan Singh, began to privatize publicly owned industries and to relax government controls in earnest. Since then India has emerged as one of the wealthiest economies in the world. Its recent growth rate of 9.1% is second only to China among the large emerging markets.

India scores 54.2% free in the Heritage Foundation's Economic Freedom index, making it "mostly unfree." Although it currently ranks 115 out of 157 countries, it has been improving slowly and steadily since the index began in 1995, gaining 9.1% over those 14 years. But even slow progress counts as progress. According to the study, every percentage point of freedom correlates to a drop in unemployment and inflation and an increase in per capita gross domestic product.

The example of Indian economic liberalization makes a strong case for increasing economic freedom. It is no longer intellectually honest to claim that restricting economic freedom benefits the people. Economic authoritarianism inevitably breeds economic malfunction.

Despite its slow economic improvement, however, India still ranks as mostly unfree. And unfree economies are scandalously wasteful. Indian government enterprises are only about 10% as efficient as the average U.S. output, and private-sector Indian firms attain only 40% of the U.S. level.

Because of globalization, emerging markets today develop much more rapidly. Poor countries like India do not need to reinvent the industrial revolution. They can benefit from the world's knowledge and experience and double their economies much quicker than it took historically. If industries in India used these best practices in technology today, they could triple their output per worker. But because of its lack of freedom, the country uses only a small portion of the rich store of world knowledge.

Poor countries are poor partially because their companies are not free to choose the best technologies. In India, obtaining a business license requires endless trips to government offices and can take a year or more.

India's lowest scores in economic freedom correlate directly with its lack of financial freedom. The country has 28 state-owned banks that control three fourths of all loans and deposits. The government also owns nearly every rural and cooperative bank. Banks are forced to lend to those who are deemed priority borrowers. Foreign ownership of banks is severely restricted.

India even legislates a list of items banned from production in large-scale plants. And because such lists are updated regularly, the potential for bribery is rampant. Like other BRIC countries, centralized planning breeds corruption. India ranks 72nd, tied with Brazil and China, out of 179 countries in Transparency International's Corruption Perceptions Index.

India has a saying for such frustration: "The fence itself grazed through the field." A fence is intended to stop cattle from grazing on your land. But what if the fence is the culprit? For that problem, you need fewer fences, not more. The best check on greedy people certainly is not to create a whole caste system of government bureaucrats and then tempt them with an overabundance of laws to enforce subjectively.

The United States would do well to learn from this example. Far too often, people react to problems by saying, "There ought to be a law." Think of the Indian proverb and translate this sentiment to "There ought to be another fence grazing through my field."

India represents only about 5.6% of the Emerging Market Index. Investments in India have done very well. Although the MSCI India Index is down 12.63% over the past year, this has only pulled the annual average return over the past five years down to 27.25%. India has been volatile but very profitable.

The Indus India Index consists of the 50 Indian stocks selected from a universe of the largest companies listed on two major Indian exchanges. Although mostly energy (28%) and materials (15%), the third and fourth largest sectors are information technology (14%) and telecommunications (8%). These industries represent India's large knowledge outsourcing.

Many of our primary contacts with India occur when we call there, thinking we are reaching an American company's help line. At first, India was the butt of help-line jokes. But now the punch line is more likely to be that you knew your tech support person was in India because he spoke English too well and could solve your problem.

We should celebrate how rapidly India is pulling its people out of misery. Globalization enhances people's welfare to the extent that they participate in the global economy. And the process of globalization is positive even when it empowers abuses and creates sweatshop conditions.

Consider the 100,000 waste pickers in India living on less than a dollar a day who sift through the garbage from Delhi. They recycle about 60% of the city's plastic, paper, glass and metals and were doing it long before it became commonplace in the United States. The stench from the rotting garbage is overwhelming; there are more flies than you can imagine. Some 300 million Indians, more than the entire population of the United States, live off less than a dollar a day.

To these Indians, a sweatshop is a step up out of the grave. They can work indoors. They can eat. They can earn more money. They can sleep under a roof.

Americans point to abuses of power and supervisors who take advantage of young women. But these abuses are only possible because employment, albeit in a sweatshop, offers the possibility of a better life. Even these abuses show to what extremes workers are willing to go to gain the value created by putting factories in India.

Additionally, American companies have nothing to gain from these abuses. Supervisors who use their position to shake down employees take value from the company. Globalization has brought democratic norms of decency and protection that have raised the treatment of women and untouchables after a long history of victimization under India's caste system.

Oddly enough, sweatshops may be the only hope for the 100,000 Delhi waste pickers. The landfills they recycle for free produce methane gas. A new waste incinerator is scheduled to be built in Timarpur, a suburb of Delhi, to collect the carbon credits under the Kyoto Protocol. Money gained from carbon credits is the primary motivation, not the environment. Although the incinerator will reduce carbon emissions, it will emit cancer-causing dioxins, mercury, heavy metals and fly ash.

Under Kyoto's Clean Development Mechanism, carbon credits generated in a poor country can be sold to a rich country and count toward the latter's emissions reductions. Oddly enough, this policy encourages the dirtiest industries and makes them more profitable. Slight improvements there can generate large credits, which the cleanest industries subsequently buy because they have trouble improving their own carbon emissions. As much as it doesn't make economic sense, Kyoto makes the cleanest industries subsidize the dirtiest.

It is already evident that Kyoto is positioned to make billionaires out of eco-traders and marginal corporations that can make coal-fired power plants slightly more fuel efficient or capture waste heat from steel plants. With great power comes great exploitation. It is difficult to imagine that carbon traders are interested in improving human suffering when millions of dollars are at stake and the World Bank is handling deals and collecting a 13% commission on every trade.

Real trade benefits real people. The unanticipated outcome of Kyoto may simply be to eliminate employment for Delhi's extreme poor. If India continues its progress toward freedom, foreign investment could do well by doing good. We can only hope more sweatshops than fences are built in place of the landfills.

from http://www.emarotta.com/article.php?ID=300

BRIC Countries: Russia (2008-09-01)

BRIC Countries: Russia

(2008-09-01) by David John Marotta

Since the fall of the Soviet Union in 1991, Russia has been trying to remake itself and regain its former glory and respect. The country's fall from superpower to emerging market deeply wounded its people's pride. Although the Russian Federation represents over 70% of the economy of the former Soviet Union, a lack of glasnost ("tell the truth") and perestroika ("decentralize power") still plagues the country.

Gorbachev rose to power in 1985. Two years later, at the plenary session of the Communist Party Central Committee, he laid out his plans for economic restructuring, or perestroika. At that point the black market represented the only real activity in a sluggish economy.

Perestroika took baby steps toward economic freedom. For the first time since Lenin's new economic policy in 1921, private ownership of some of the commanding heights of industry would be allowed. For those of us who grew up with the Iron Curtain, the changes seemed radical. After 70 years of communist propaganda in the East and socialist sympathizers in the West, classical free-market liberal views apparently had won the debate.

But baby steps were not enough to save the Soviet economy. Initially, high taxes and employment restrictions discouraged private investment. And foreign investment fared no better because 51% of the venture must be Soviet owned, and the chairman and general manager have to be Soviet citizens. Centralized planning was eliminated in favor of decentralized planning, rather than allowing market supply and demand. Price controls remained, as did state support for unprofitable enterprises. Because the culture long accepted corruption, socialism deteriorated into a more local form of cronyism. Traditional shortages became critical shortages of basic necessities. In short, Russia tried to institute certain economic freedoms from the top down rather than simply allowing them to grow organically from the bottom up. But fish rots from the head.

In August 1991, the military staged an unsuccessful coup against Gorbachev aimed at preserving the party apparatchiks. Unable to contain the furor for freedom and independence, however, the attempt simply hastened the regime's collapse and dissolution.

One of my favorite souvenirs, a KGB (secret police) 70-year anniversary pin, reminds me that the lifespan of centralized planning efforts is limited. These attempts at universal control lack the negative feedback that would encourage them to self-correct. Ultimately, unintended consequences build up, and a revolutionary upheaval explodes and causes the system to reset. China's communism won't turn 70 until 2019.

Russia has the largest landmass in the world, and before 1991 it had the second biggest economy. But today, Russia has become just the second letter in BRIC, four promising emerging market countries: Brazil, Russia, India and China.

During the Yeltsin years, Russian industries were privatized. But the process was rife with political patronage. Russian billionaire oligarchs thrived, confirming the adage "We hang the thief who steals 3 kopecks and honor the one who steals 3 million."

A currency crisis in 1998 devalued the ruble. Russia's gross domestic product (GDP) dropped by 50%, and the stock market lost 93% of its value. Russia defaulted on its government bonds. In the United States, the bond default contributed to the infamous bankruptcy of the hedge fund Long Term Capital Management.

Since then, Russia has demonstrated impressive growth. It has progressed from its standing in 1999 as the 22nd largest economy in the world to about 9th today. Its GDP has increased an average of 6% in recent years, less than China (10%) and India (9%) but about twice that of Brazil (3%). Russia's export growth is nearly 50% a year.

Russia is second only to Saudi Arabia in oil exports; energy companies Lukoil, Gazprom and Rosneft dominate the economy. The Russian stock market index is 39% oil and gas. It has a low correlation with the S&P 500 of only 0.43.

Until recently, Russian stocks were averaging more than a 40% return annually. But during much of this time, they were just recovering from their precipitous drop in 1998. Currently the Russian stock market is down over 30% year to date and struggling again. And at 13% it has the highest inflation rate among the BRIC nations, which eats into the buying power of local returns.

Russia differs from the other BRIC countries demographically. Its population, like Europe's, is both shrinking and aging. To try and reverse this trend, the government offers 250,000 rubles (about $10,000), equivalent to an average yearly income, to women who have a second child.

After a brief encounter with chaos under Boris Yeltsin in the 1990s, Russia moved back to a more authoritarian "managed democracy" during the reign of Vladimir Putin (2000–2008), a former high-ranking KGB official.

This is where Russia's troubles lie. Although it never really tried free markets, Russia has fallen back into the familiar weaknesses of a controlled economy hindered by bureaucratic restrictions, inconsistencies and corruption. Rated at just below 50% free, Russia earned the Heritage Foundation's lowest economic freedom ranking, repressed and on a par with countries like Vietnam, Guyana, Laos and Haiti.

Russian laws do not protect private property. State involvement in the economy has been increasing as the country has retaken its "national champion" industries of energy, shipping, shipbuilding and aerospace. Some of these takeovers represent a renationalization of industries of strategic geopolitical importance under Kremlin control. Some of them are retaliation against those who acquired their wealth in the Yeltsin years by raiding. These are popularly justified as stealing from the thief. In the absence of law, evidently power is all that remains.

And power is wielded at every opportunity. Russia ranks 121 out of 163 countries in Transparency International's Corruption Perceptions Index. Corruption is both widespread and brazen in the number and size of bribes sought.

Enforcing contracts is difficult. The judicial system, corrupt or at best inconsistent, cannot handle complex cases. When money talks, the truth stays silent. As a result, intellectual property rights are routinely violated.

Even President Putin described the corruption and cronyism. He said, "One of the most acute questions is inactivity, red-tape and excessive control in the business life of many regions. Administrative intervention is out of proportion, local markets are monopolized, closed to any activity from the outside, the local authorities are often used as a tool of unfair competition and are vulnerable to corruption."

Until recently, investment in Russia was attracting interest, but positive past returns should never be the primary reason for investing. The invasion of Georgia makes it clear that the Russian ethos still depends more on political thugs than on freedom and the rule of law. Investments in Russia are owned only at the whim of current political opinion. Therefore, we suggest you limit any assets invested in Russia to a very small portion of your emerging market allocation.

from http://www.emarotta.com/article.php?ID=299