Break Out Nations By Ruchir Sharma

Microsec Capital Limited

 Managing Director and the head of the Emerging

Markets Equity team at Morgan Stanley Investment Management and manages 25 Billion USD funds to be put in Emerging Markets

About the Author

Previously worked with Prime Securities Limited (Delhi), where he ran the firms foreign exchange business Graduate from the prestigious Sri Ram College of Commerce, Delhi and a CFA Charterholder

Passionate writer, has been writing regular columns on global financial markets since 1991
Contributing editor with Newsweek ,has written for The Wall Street Journal and also a contributor to The Economic Times

Broken down as an economic travelogue Searching for the big idea 2010 came back to India-Delhi- farmhouse-railroadchefs flown in from different parts of the world Young 25 yr old-got chatting global investor back in India

The Making of the Book

Overconfidence -where else will the money go, Mantras- The inevitable never happens, the unexpected does, The past is not the prologue
Russia who needs your money-Putin

Index

There are about 180 economies tracked by the IMF Developing economies represented less than 20 percent of the global economy and 5 percent of the worlds stock market capitalization, as of 2011 the numbers were 40 percent and around 15 percent respectively Only 35 countries are developed countries and the rest are emerging or frontier countries Its a game of snakes and ladders Cannot treat the emerging markets as a homogeneous bunch Treat individual countries and take it country by country
5

Emerging Nations Basket

Failure to sustain growth is the general rule Only 1/3rd of emerging markets have been able to grow at an annual rate of 5% or more Less than 1/4th have kept that pace for two decades

Not All Trees Grow to the Sky

1/10th for three decades

6 countries (Malaysia, singapore, South Korea, Taiwan, Thailand and Hong kong) over 4 decades

South Korea, Taiwan for over 5 decades

Similar for Companies

The Decade Gone By

Has been Freaky to say the least and not likely to be repeated in a long time
Emerging Markets

Funds flowing to Emerging Market Stocks

2000 2005 92% 2005 2010 478%

Decade Gone By (Growth in GDP )

8.0% 7.60%

7.0%
6.0% 5.0% 4.0% 3.0% 3.5% 5%

2.0%
1.0% 0.0% 1980-2002 2003-2007 Going forward

World Fact book according to CIA 2011 estimates

Country Population GDP Real Growth Rate 2011(Annual %) as per CIA WORLD FACTBOOK No. of Nobel Laureates(as per wikipedia) Brazil China Czech Republic India Japan Mexico >114 Million 4 Russia >143 Million 4.3 Sri Lanka Taiwan Turkey Vietnam >192 >127 >1.3 Billion >10 Million >1.2 Billion Million Million 2.7 9.2 1.7 7.2 -0.7 > 20 >23 Million >74 Million >91 Million Million 8.2 4 8.5 5.9

10

19

27

GDP composition by sector(%) : Agriculture Industry Services

Population below Poverty(%) Investment (Gross Fixed) % of GDP Taxes and other Revenues(% of GDP) Labor Force Budget Surplus(+) Or Deficit(-) % of GDP Public Debt(% of GDP)

5.5 27.5 67
26.8 ('08) 19.3 39.2 104.7 Million 3.1 54.2 6.6 6

10.1 46.8 43.1

13.4 54.2 22.6 795.5 Million -1.1 43.5 5.5 6.5

1.6 38.1 60.3

9 ('10) 23.9 23.9 5.41 Million 3.7 40.7 1.9 8.5

17.2 26.4 56.4

27('07) 32.8 11.7 487.6 Million 6.7 48.5 8.9 9.8

1.2 27.3 71.6

16('07) 20.9 33.6 65.93 Million -8.9 211.7 0.3 4.6

3.8 34.2 62
18.2 21.1 22.8 49.17 Million -2.5 35.4 3.4 5.2

4.5 36.9

13 29.6 57.4
8.9('09) 27.3 14.4 8.307 Million -7 79.4 7 4.2

1.3 32 66.9
1.16 21 16.1 11.2 Million -3.3 36.3 1.4 4.4

9.3 28.1 62.6

16.9 21.8 22.7 27.43 Million -1.3 39.9 6.5 9.8

22 40.3 37.7
14.5 34.6 26.7 46.48 Million -2.4 57.3 18.7 2.3

13.1('10) 21.3 20.7 75.41 Million 0.4 8.3 8.4 6.6

Inflation Rate (consumer prices) %

Unemployment Rate %

The Rules of the Road

 There are two types of Government System i.e. democratic and autocratic

Type of Government System

In autocratic you may be right or you maybe wrong you do not know as there is no feedback system In democratic system there could be very slow decision making or there maybe a paralysis in decision making For every China there is a Vietnam
Autocratic
China Russia Taiwan Singapore

Democratic
India Indonesia Japan Malta

50/50 rule : political systems dont impact growth for better or worse, political leaders do
10

Be alert to the moment when rulers have outlived their usefulness

Speeches of Radical Politicians

It is a worrying sign when leaders try to extend their hold on power, their focus shifts to protecting vested interests or they simply run out of progressive ideas In the emerging markets, leaders take credit for boom times and blame bad times on the west

11

AVERAGE TOTAL NET TOTAL NET NET WORTH NUMBER OF WORTH (in WORTH (as % (Of top 10, in COUNTRY BILLIONAIRES US $ billions) GDP) US $ billions)

The Billionaires' Index

Russia Malaysia India Taiwan Mexico Saudi Arabia Turkey Brazil Philippines Indonesia Korea China

100 9 55 25 11 7 38 30 4 14 16 115

431.8 44 246.5 62.4 125.1 54.8 63.7 131.4 11.4 32.3 39.6 230.4

29.2 20.1 17.2 14.6 12.5 12.4 8.7 6.5 6 4.6 4 4

16.8 4.9 14.8 4.1 12.4 7.8 2.8 8.8 2.9 2.8 3.2 6

Source: IMF World Economic Outlook,April 2011

12

If a country is generating too many billionaires relative to the size of its economy, its off balance If a countrys average billionaires has amassed tens of billions, not merely billions, the lack of balance could lead to stagnation If a countrys billionaires make their money largely from government patronage, rather productive new industries, it could feed resentment. Billionaires should emerge predominantly from productive economic sectors progressive ideas The Sectors from which they emerge is very important. In case from realty, mining it means government patronage. There should be constant churn over a period of 5 years and emergence of new billionaires

Teachings from Billionaires Index

13

The four Seasons Index

City (Name of alternate property if applicable)1 Moscow(Ritz-Carlton) Sao Paulo DEVELOPED MARKETS AVERAGE4 Turkey Istanbul3 United Arab Emirates Dubai(Ritz-Carlton) Nigeria Lagos(Federal Palace) Argentina Buenos Aires Czech Republic Prague Saudi Arabia Riyadh EMERGING MARKETS AVERAGE Mexico Mexico City Hungary Budapest Egypt Cairo3 India Mumbai South Africa Johannesburg(The Westcliff) China Shanghai Poland Warsaw(Le Royal Meridien) Thailand Bangkok Indonesia Jakarta Malaysia Kuala Lumpur(Ritz-Carlton) Colombo(Galle Face Hotel-Regency Sri Lanka Wing) Country Russia Brazil
1. 2. 3. 4.

Rates in USD($)2 924 720 704 659 613 597 520 517 460 441 440 421 380 378 365 359 271 234 230 160 156

Differences vs. Emerging Average 109% 63% 60% 49% 40% 35% 18% 17% 4% -0.30% -5% -14% 14% -17% -19% -39% -47% -48% -64% -65%

If the city has no Four Seasons, the first alternate is Ritz-Carlton, followed by comparable hotels. Rates are based on standard rooms from the hotel websites as of August 8,2011. In cities where two Four Seasons are located,the average price was used. Developed markets average based on Four Seasons in the following cities:Chicago,Geneva,Hong Kong, London,Milan,New York,Paris,San Franscisco,Singapore,Sydney and Tokyo

Teachings from Four Season Index

If the local prices in an emerging market country feel expensive even to a visitor from a rich nation, that country is probably not a breakout nation Countries today with most expensive currencies are Brazil and Russia which are majorly commodity exporters Cheap currency is a sign of competitive strength

International investors look at total returns

15

 Oversized capital cities often indicate excessive power in the hand of the political elite Check the size and growth of the second city, compared to the first city

Size of second Cities

In any big country the second-largest city usually has a population that is at least one-third to one-half the population of the largest city This ratio reflects regional balance in the economy, and it holds true for many of the nations that were breakout stories in recent decades Its a red flag if a country is stuck in violation of this rule, but its a good sign if a capital-centric nation is moving towards greater balance

Its even better if the country is producing new cities with population of one million or more, which suggests that is lifting all regions .Indonesia fits both criteria
16

The law of large numbers

The richer a country is, the harder it is to grow national wealth at a rapid pace China and other emerging markets are following an export driven growth model Japan, south-Korea, Taiwan, began to slow from 9 or 10 percent to 5 or 6 percent when their per capita reached upper middle income group World Bank defines upper middle-income level as $4000 per capita income or more.

Per Capita Income Levels or the $4000 Index

17

Economic regimes are like markets: when they are on a good run they tend to overshoot and create conditions for their own demise By the time a regimes rules have been codified by experts and hashed over in the media, it is likely already in decline Once an economic indicator get too popular, it loses its predictive value In emerging markets, leaders take the credit for boom time and blame bad times on the West. Going global may not be a good sign for countries which still have underdeveloped consumer markets.

Economic regimes are in constant flux

18

Locals are the first to Know

Learn the macroeconomic numbers, then go to the country and kick its tyres, get a feel for the story. Locals are the first to know The prices of black-market money changers, The travel habits of local businessmen(whether they are moving money home or offshore )

19

Strong companies and stock markets should-but do not necessarilymake for strong economies

In Brazil the high cost of borrowing has forced publicly traded companies to be extremely disciplines and therefore they are highly profitable. Big reason for Brazils stock market rise of 300% in $terms despite its slower economic growth

Stock markets should rise in value when the economy is growing, in recent in the emerging world, this phenomenon has not happened. E.g. South Korea- in 1989 KOSPI peaked despites slow growth of 6 % until Asian financial crisis of 1997
Companies saw the stock market as a place to raise quick money, rather as a basic measure of their long term value As companies have started to focus on profit, stock market shave started to rise(and fall) with emerging economies.

The more accurately a stock market reflects the real economy, the more important it becomes as a signal of where the nation is headed
In places like India, the stock market eventually became a kind of stand-in for public polls: stock market reaction is taken as the judgment of budget decisions

20

Dont get hung up on Rules

Dont get hung up on rules. In the past, when manufacturing accounted for 25 to 30 percent of GDP, the manufacturing story typically reached its natural limits and the economy started to shift focus to services

South Koreas manufacturing sector is still expanding steadily, it might be carving out a rare exception to the normal evolutionary path
Not every little EU member is a Greece and nations should not be type casted. Poland and Czech Republic to join the elite

21

Check out the Earnings Indicators

If more than 50 percent of a nations corporate earnings are coming from abroad, it could be reason for concern Going global can a sign of corporate strength or of national weakness If Singapore, where businesses cant make all that much money at home because the population is so small, it is not alarming that more than 50 percent of earnings are made overseas Going global is not always a good sign: for countries like mexico or south- Africa, which have still underdeveloped consumer markets

22

Check the Flow of Money

Investing in the education communication and transportation systems are necessary to raise productivity The key to high growth with low inflation Worldwide flow of easy money Speculative oil futures Luxury real estate

Non productive investments

Countries like Brazil and Russia have been culprits of not able to handle the commodity boom bust cycles and saving for the rainy days

23

The strongest corporate model is family owned but publicly traded and professionally managed Family firms beat global stock market returns by an average of 3% a year between 1997 and 2009 and came out of the 2008 crisis in much better shape than non family rivals, with less debt, more cash and higher R & D investments throughout the downturn. Warren Buffet They are great, until the families start fighting

Miscellaneous

24

USA 1% to 2.5% Average 3%

Remarkable amount of resilience in the face of the problem of Government debt

Will go back as the largest contributor to global growth Competitive Exchange Rates 1/3rd of R& D spend in the world is done in US Wage growth in US is low making it competitive vis a vis China. Concept of Reshoring. Oil Boom Enjoyed, shale gas technology

25

Total debt as a share of GDP is rising fast, and the advantage of cheap labor, a key to the Chinese boom, is rapidly disappearing, as the labor shortage gives workers the upper hand in contract negotiations
The exports that have powered Chinese growth will also slow as the West struggles with its debts. Over the past decade Chinas exports have grown at an average yearly pace of 20 %, and that is bound to come down. In 1998, when China was a $1 trillion economy, it had to consume only 10 % of the worlds industrial commodities to expand its economic activities by $100 billion. In 2011, when it was $6 trillion economy, it needs to consume more than 30 percent of global commodity production to expand its economic activities by $600 billion. The point is China is too big to boom In the last decade the main driver of Chinas boom was a surge in the investment share of GDP from 35percent to 50 percent, which in U.S. and Europe were only 15 percent and 20 percent respectively. This investment turned China into the worlds largest exporter, doubling its global export market share to 10 percent. This spending spree cant continue. By 2010 government had already laid out plans to cut back Only 5 million people between the ages of 35-44 will join Chinas core labor force this decade, versus 90 million in the previous decade. China is aging, which will curtail its growth potential.

Why China will not Grow

26

Deregulation of Islam Getting Economic Act Together Economic Reforms Not Aspiring to join European Union

Turkey

Focus right on growing economy you can get away with a lot more
Regional Powerhouse

Only 15 nations is excess of trillion dollar economy, Turkey & Indonesia to join the same

27

IMF GDP Forecast

TIP 2012 2.30% 4.20% 6.10% 2013 3.20% 4.70% 6.60% 2017 4.60% 5.00% 7.00%

Turkey

Turkey Indonesia Philippines

TIP Turkey Indonesia Philippines

Source: Breakout Nations

Current P/E 9.70 15.40 16.20

28

Indonesia was the country hardest hit by the crisis of 1997-1998, but it also learned the deepest lessons, which is the reason it thrived after the 2008 crisis.
It dodges the global downturn of 2008, without the massive spending binge employed by China. Indonesia got through the crisis largely unscathed, with less debt than it started under the leadership of the president SBY President Susilo Bambang Yudhoyono ( SBY) ran on promises to pursue economic recovery and signaled his seriousness by picking a respected technocrat over the favorite sons of allied parties as his running mate. Large population and a wealth of natural resources are now seen as providing a competitive advantage-Indonesia is the worlds 4th most populous nation, the country has a large enough domestic market to generate demand even when global demand is weak.

Indonesia

Indonesia is now by far the best-run large commodity economy. It also has vast untapped reserves of crude oil, coal, palm oil, and nickel.
Indonesia has much lower structural inflation than Russia( 6% compared to 10), and because it is investing (rather than consuming) more than both Russia and Brazil, it should be able to grow at a faster pace in the years ahead.

29

In economic life, happiness is relative, not absolute Hype that China will overtake western economies will fade away The big story will be that China is too and too middle-aged to grow so fast. Emerging markets is a new concept from an investment standpoint The First Coming of emerging markets dates to mid 1980s, when The Wall Street started tracking it as a distinct asset class Firstly labelled as exotic- emerging nations started opening their stock markets for the first time to outsidersTaiwan in 1991, India in 1992, South Korea (to small minority shareholder) in 1993, Russia in 1995. From 1987- 1994- amount invested in emerging nations rose from 1% to nearly 8% of the global stock market total, unleashing a chaotic 600 percent boom in prices in dollar terms. The First Coming halted with a series of economic crises between 1994 and 2002, that struck from Mexico to Turkey.

The Third Coming

The Miracle Is Younger Than It looks

The Miracle Is Younger Than It looks

1994-2002, emerging stock markets lost half of the value skidding back to 4 percent of the global total. Between 1987-2002, emerging market share fell from 23 % to 20 percent of global GDP, except CHINA which doubles to 4.5%.
The Second Coming began with global boom in 2003, emerging markets starts as a group, their share of global GDP rose from 20% to 34 % today, share of global stock market rose from 4 % to more than 10%.Since 2009 it has been slowing. Now entering a Third Coming, era of moderate growth, boom-bust cycle, and break-up of herd behaviour. 20032007 stock market returns averaged 37%, likely to slow to 10 percent annually in the coming decade.

The Breakout Nations

The growth game is all about expectations. For India the slip from 9 to 6-7 percent growth rate would feel like a recession initially. In 2011 , growth rate of 7% was enough to trigger a bear market in the Indian stocks.

In the very large $10000-$15000 category, only Turkey has a chance to match or exceed 4-5 percent.

The breakout speed for countries with an average per capital income of $5000 or less is 5% or faster
Nations Average Per capita income $5000-$10000 Growth Rate expectation 5%

$10000-$15000
$20000-$25000

4%
3-4%

Thanks !!

If there is no wind, row

33