The frontier markets fallacy

1st June 2012

Failing at the frontier

Mongolia was the fastest growing frontier market over the past two years. According to the Financial Times, the tiny $1.5bn market gained 73% last year and 121% in 2010.

And that should make it the world leader in an investment universe of Brics and Civets – the biggest and next biggest emerging markets, the layer above the frontier. The Brics are Brazil, Russia, India and China, while the Civets consist of Colombia, Indonesia, Vietnam, Egypt, Turkey and South Africa.

Make Most Rich

Despite the Mongolian success, it has not been plain sailing for those on the frontier as this MSCI chart shows.  But that should not stop the acronym creators including Mindful Money which today presents MAKE. Mineral rich Mongolia – a nomadic nation the size of Western Europe with a population of under three million – provides the first letter while Argentina, Kenya and Estonia are the other three. There are other possible acronyms of unlikely bedfellows – Most (Mauritius, Oman, Sri Lanka and Tunisia) or Rich (Romania, Ivory Coast, Cambodia and Haiti).

What links these groups of four countries? Absolutely nothing other than a convenient set of initials – just the same as the non-ties between the disparate nations of the Brics and the Civets. 

Creating these acronyms is just an extension of an old investment concept which today's equity and bond buyers have fallen in love with once again.  Providing they buy into the right national economy, they are on the road to riches. The countries which are held out as winners generally have one of two characteristics – they are rich in natural resources (Brazil, Russia) or have a fast growing middle class which has gained riches on the back of a still huge peasant and a low paid factory work economy (China and India).

But by focusing on the positives that make the investment case, and sucking in those who are attracted by assets which have already risen (thanks to buyers who got there before them), there is a danger that investors will miss the bigger picture, including the national negatives. Stock picking on a top down basis – start with the nation and work down to the individual company, rather than a bottom up process (starting with equity or bond) – can be fraught with danger.

A new book Why Nations Fail (and by extension although it does not work nearly so well as a catchy book title Why Nations Succeed) – subtitled the Origins of Power, Prosperity and Poverty, takes issue with whether some of the emerging and frontier market countries can make the longer term transition to developed economies without major socio-political change. It could also be that climate changes sends them backwards.

China risks running out of steam

The work, by academics Daron Acemoghu, a Turkish American economist and James A Robinson, an American political scientist, throws doubt over the inevitability of Asian success and European/North American failure. Chinese growth prospects seem to many – including investors and fund managers with an interest in the area – to be virtually limitless while those of the developed world seem to be set for long term irreversible decline. But not to Acemoghu and Robinson who warn that "China's growth is likely to run out of steam."  It fails on many corporate and social governance issues.

They say that wealth based on natural resources tends to remain with a tiny elite unless – the country in question has a track record of good governance. While it is no guarantee of sustainable government, this record needs to be over a long period. Those that have more recently emerged have a far more difficult task.

Europe, and by extension European colonies such as South Africa, North America, and Australia – generally but not always win on this basis – Argentina is an exception. Europe has had more than 2,500 years of some form of successful governance while many ex-colonies in Africa have had under 50 years to get it right.  Even Argentina, a European settled colony with a poor governance reputation looks good by comparison with much of tropical Africa.

Gap between rich and poor nations grows

The gap between rich and poor has accelerated over the past half century with those nations backed by a history of stable governance outplaying the others. For instance, the authors cite South Korea and Ghana, both equally poor in the 1950s.  South Korea has had good governance while Ghana has suffered dictators and civil war since independence. Today South Korea is far richer and far more peaceful. Africa funds have often had a torrid time despite their ability to come up with an apparently compelling investment rationale.

Russia has immense riches to extract. But thanks to a history of bad governance which has helped engender endemic corruption, only a few have gained from these resources, despite rising commodity prices.

Natural resources a curse, not a cure

The authors claim that there is a "Curse of Natural Resources".  Certain commodities such as diamonds and oil tend to promote corruption, civil war, and the neglect of women and children as their extractive industries hold back development because so few share in the wealth.  And countries that use their resources too quickly – sometimes mortgaging them to pay off the interest on international loans – end up more impoverished than if they had never had the forests and mines in the first place. Without strict party control, many fear China could become an ungovernable tinder box.

Other nations, such as Japan, which have few resources, have had to invest in education and health instead.

Resources are not always a curse. The authors cite gas-rich Norway and oil-wealthy Trinidad and Tobago as nations which have benefited from what is under the ground by investing in education and welfare. Norway is now the world's 2nd richest country while Trinidad is fast approaching equal footing with much of s
outhern Europe.

The north-south divide

There is also a very clear north-south divide. In Africa, the nations at the very north and south have better prospects than those in the middle. The tropical nations have less developed agriculture thanks to a shorter history and poorer soil and weather conditions, and a greater propensity to disease such as malaria. Mosquitoes and microbes cannot winter in Europe but survive in hotter climates, leading to greater illnesses, higher infant mortality and the need for more children to be born to replace those who die.

The book is often bleak.  But it has a clear message for investors. It's OK to believe in the emerging and frontier nations – providing it is for the short term as it might only last as long as others believe it will.  Much of the cash powering the Brics, the Civets and the Makes is hot money which, on past experience, is ready to chase whatever is the new best thing. Anything longer term may demand an act of faith that goes contrary to the socio-political history of the past many thousand years.


More on Mindful Money:

BRICs, bribery and corruption

Should Russia be blocked from the BRICs?

Why the BRICs will fall

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The Financialist

29 thoughts on “The frontier markets fallacy”

  1. Anonymous says:

    Hi Shaun,

    I’d suggest that Germany has several regional economies – places with strong export industries ( Bavaria & others ), others with demographic decline where there are towns with many empty houses and the former GDR lander with huge unemployment (I’ve read that Poles are now living in Germany and commuting to jobs in Poland to get cheaper housing). Housing investment only makes sense in the first regional type, with Munich (for example) seeing huge house price increases.

    An economic principle – profit can be enhanced by productive investment. Germany has recently squandered much money in buying US MBS’s and loans to Greek, Spanish, etc banks. Money directed to various EC “rescue funds” like the ESM and EFSF cannot be classed as productive investment either. Therefore I am not surprised that the German economy is struggling while huge rewards are delivered to unproductive failing banks and bankers.

    1. forbin says:

      And Thus the great European experiment continues to strangle the German Golden Goose .

      The Germans cannot afford to bail the the rest of Europe out – too big a debt problem

      mind you do these figures mean they ‘ll be embarking on a fevered housing boom a la UK – with the same dire results ? ( house prices too expensive ) or a la Spain ? ( too many houses – valued at too higher cost ? )

      I agree with ExpatlnBG . they’ve throw a lot of money away here, I wonder if the German Electorate really know whats going to hit them……


      PS: interesting isn’t it? popcorn ready for 2013 !

      1. Anonymous says:

        I guess the German property investors fear inflation and worry about monetary stability. Property is an inflation resistant investment.

        The German planning system is less restrictive than the UK, so anybody can acquire land for their own home. (Self built or done by a small local builder) This reduces the demand for houses built down to a price by large developers, which in turn should prevent an oversupply a la Spain. Also the German banks are unlikely to authorize risky lending – given hindsight of the Spanish problem. –
        Therefore I’d guess the risk is high prices localised in areas of high employment (a la London)

      2. JW says:

        Germany’s public debt is at about the average EZ level ,82%, which is considerably below the level of the US. Whilst Germany’s exports over the last 15 years have increased substantially the overall GDP has risen less than that of France, UK and a lot of other EU countries. General wage levels and standards of living have remained flat for 20 years for the majority of Germans. Why? Because so much of Germany’s exports to other EZ countries have never been paid for. They exist as credits in the Bundesbank’s balance sheet, so in essence the Bundesbank is supporting German exports with public money. As the ECB creates more liquidity , the more the German people pay, but the elite in Germany just like everywhere else get richer and richer.

        Its Germany’s own 0.1% who are ripping off their own people under the mirage of an export-led economy.

        1. Anonymous says:

          That is nonsense, I’m afraid. The Bundesbank’s claims on the ECB in the Target2 system are the balancing item for real money actually received by private sector banks as payment for exports and repatriation of foreign deposits. To say this amounts to monetary financing of German exports is simply wrong and shows a lamentable lack of understanding of how RTGS settlement through the Eurosystem works. I don’t want to explain it here, but I suggest you read Karl Whelan or Beate Reszat on the subject of how Target2 works.

          1. JW says:

            Payments for exports from Germany to say Spain are held as credits by the Bundsbank from the Bank of Spain. The net total of Target2 is indeed a net of debits and credits, it currently is a credit of over €700bn held by the Bundesbank.
            This is the second thread you have used ‘rude’ language like ‘nonsense’ and ‘lamentable’. I didn’t realise this blog was an excuse for you to prove how much more clever you are than a mere ‘amateur’ trying his best to make sense of this crazy world. Perhaps you would like to engage a portion of your brain labelled ‘humble’ before hitting the keyboard in future.

          2. JW says:

            The links below describe the contrary views of TARGET2. The second quotes Whelan extensively.



            Leaving aside the technicalities of double entry accounting, I think the major difference of view is the effect on Germany’s ‘currency’ and inflation if the increasing public debt obligations as a result of the TARGET2 credits were met internally.

            My opinion is that whilst the exporting institutions , whether they be companies or banks are held intact by the Bundesbank, the resultant public debt obligations and inflationary effects will as usual be dumped on the ordinary taxpayer. To believe this could unravel by simple accounting write-offs is I believe naive and therefore I don’t think Whelan’s arguments are sound.
            But I repeat, that is only my opinion, far more knowledgeable commentators seem to have widely differing views.

          3. Anonymous says:

            Once again you resort to ad hominem attacks on me rather than considering what I actually wrote. I was not rude to you personally: I criticised your comment, that is all. it is not “rude” to describe something that is completely wrong from beginning to end as nonsense. But you have once again been extremely rude to me.

            I am sure if Shaun did not like the tone of my comments on this site he would tell me so. And I will continue to comment on this blogsite as long as Shaun is happy for me to do so. If you don’t like that, frankly that is your problem, not mine. As I said before, you need to develop a thicker skin – and accept that you may, just occasionally, be wrong, and that people are not being rude to you when they point this out.

            It is the ECB that stands to take losses in the event of a country leaving the Euro, not the Bundesbank. The question is whether the ECB would then require recapitalisation – and that depends on your view as to whether technical insolvency in a central bank is a problem. However, recapitalising the ECB would be a joint responsibility of the entire Eurosystem, not just Germany.

            I have previously read all the links you have provided and a good many others too. I really do strongly recommend you read Beate Reszat on this subject. I would say she has the best actual knowledge of how this works and takes a balanced view.

          4. JW says:

            I will keep this short because I don’t like these sort of comments on Shaun’s blog.

            Your comments re the ECB demonstrate that you didn’t either read my comments or understand them prior to jumping to write ‘nonsense or lamentable’. Of course you are completely entitled to your opinion/views, but so am I. From what I have read there are many commentators who share my opinion and many that share what I think are yours. Quoting names of university economists doesn’t make your view any more ‘right’. Economists as a bunch are pretty incompetent when trying to explain what happens in the real world. Their training is to blame. Compared to physical scientists they are still in the 19th century, they have no idea of how to explain/model dynamic , chaotic events. Unfortunately that means that most ‘events’ come as a big surprise to them.
            Lets just agree to disagree and in future I will try not to comment on your views in case it starts another ‘disagreement’.

          5. Anonymous says:

            On the contrary, I read your comments and understood them. And I gave my opinion of them. You are entitled to your opinion/views, and I am equally entitled to say that your opinion/views are factually wrong. Unfortunately you interpreted that statement as a personal attack, which it was not, and you responded in kind. You’ve just come out with a whole lot more opinions/views that I don’t particularly agree with, but as every time I disagree with you you accuse me of arrogance, I’m really not interested in debating with you.

          6. JW says:

            Using words ‘nonsense’ and ‘lamentable’ is not ‘giving your opinion or disagreeing. Its a clear attempt at a ‘put down’. You are a very disagreeable arrogant poster.

          7. Anonymous says:

            Well, if you want to interpret it that way that’s up to you, though I think you are way too sensitive. But the ad hominem attack count is considerably higher on your side than mine. You were rude to me on my very first post at this site – which was not even addressed to you. “Disagreeable arrogant poster”? Look in a mirror.

          8. JW says:

            And here is one that very politely disagrees with Reszat


            including the statement ‘ If the Bundebank loses its TARGET claims, it is a loss for the whole nation.’.

            Pays your money takes your choice.

        2. Anonymous says:

          West German living standards remained flat or even dropped. East German living standards have increased hugely, Eg no more queuing for bread.

          German wealth statistics and debt have been muddied by reunification and the enormous wealth transfer from the west to the east.

          This redistribution has not bought enough employment to the east. Worse still, Poland is attracting more FDI than East Germany and creating more employment.
          I would suggest that tying the Ostmark to the DMark has not helped East Germany to develop a successful economy with high employment rates, and that a lower value Ostmark could have helped spur FDI and job creation. Is there a lesson for the eurozone here ?

          1. JW says:

            Hi ExpatinBG

            A lesson indeed. The ‘savings’ of the West went East in capital exports to the ‘East’ . Then over the last decade the majority of German ‘savings’ has been exported ‘abroad’ mainly to the periphery. Leaving less than ‘normal’ for internal growth. Inflationary growth in the periphery balanced by relative depression in Germany, disguised by a positive balance of trade. More of the same is likely to have the same result.

    2. JW says:

      I think regional variations applies to every country. In Europe all the adjoining areas of countries next to Switzerland are doing relatively better than elsewhere. Not surprising given the pump-priming leaking out of the SNB.

      1. Anonymous says:

        The Swiss pump priming is very recent – it cannot be credited for boosting Bavaria (home to BMW & Audi), Baden Wurttemburg (Mercedes Benz). It’s investment in quality & innovation to build products that command a price premium.

        1. JW says:

          I was making the observation that other countries have regional variations and co-incidentally ( or not) , France and Italy have relatively bouyant regions abutting Switzerland. They always tend to be, but the Swiss wealth leakage hasn’t harmed them.

    3. Anonymous says:

      Hi ExpatInBG
      I can see you have plenty of replies but let me just add that a lesson of the Euro crisis has been to remind us of the regional nature of all economies and the compromises and transfers which take place. I can’t think of a homogenous country….

      1. Anonymous says:

        Agreed. I looked at how Poland’s low exchange rate, cheap labour from the early 1990s has slowly spurred people to make productive businesses and created gainful employment. In contrast the former GDR lander received huge subsidies while using a “foreign controlled” hard currency that kept wages and living costs disjointed from local productivity. This causes mass unemployment.

        I suggest that Greece is repeating the same mistake – they are using a hard “foreign controlled” currency that is not matched to local productivity and/or consumers means.

        If my theory is correct – eurozone Greece will continue to have high deficit and high unemployment for many years. Grexit and devaluation seems a better choice.

  2. jw says:

    Hi Shaun
    2012 saw a real increase in average German wages and they expect a small increase again in 2013. There is an almighty row going on about whether this is/will undermine the great German industrial machine.

    Its a very very small step in adjusting the relative productivity gap across the EZ totally dwarfed by the drastic effects in the ‘sunshine belt’.

    If retail sales are not increasing where is the money being spent? Some of it is supporting an increase in domestic house prices, but I would have a small wager that quite a lot is supporting a different house investment location; Florida and Arizona. In selective areas of these States there has been renewed investment and a lot of it is from ‘overseas’. If you look at the names of new agencies etc they have websites in German.

    1. Anonymous says:

      Hi JW

      Yes I had spotted the numbers on the German Statistics website which did give a bit of food for thought. After a dip to an annualised fall of 1% in mid-2009 they moved into positive territory in 2010 and 11 according to its chart . Germany doing its bit? We will have to see how this plays out this year.

  3. pavlaki says:

    Very interesting figures! Certainly the Germans determine that the interest rate and the value of the Euro shall suit Germany first and foremost – which of course is diametrically opposed to what the south of Europe needs. If they want the south to grow they are going to have to live with higher inflation (or at least the risk of it).

    1. Anonymous says:

      Is the euro an unrealistic project ? Is a single interest rate workable ?

      Banks have loaned too much money to some southern European countries. Greece is insolvent. Spain’s banks appear to be hiding their insolvency. The EC approach is to deny the possibility of separate currencies and to insist the Northern European taxpayers pay the debts of the profligate and probably corrupt Southern politicians.

      There are other ways of resolving the Greek problem. Greece could default on bonds and retain the euro or default and exit currency union. Greece could reclaim assets from enormously rich politicians (and others) who cannot prove how they acquired their assets on their declared taxable incomes.

  4. Midge says:

    When your head is spinning with the unbelievable amounts being thrown at the world’s economies(banks) along comes talk of a trillion-dollar coin.Now that’s the answer to all the problems.

    1. forbin says:

      Hello Midge,

      That nudged a brain cell – wasn’t there a film about the million pound note – old black and white one …..

      How inflation has affected everything!

      perhaps we need a Quadrillion pound note instead ….


      ah here it is – “”

      1. forbin says:

        “..that the mere existence of the note will enable the possessor to obtain whatever he needs….”

      2. Anonymous says:

        Hi Forbin
        Gregory Peck I think was the star and the possession of it meant he then didnt need to spend anything as he then was given all he wanted. How times change! The amount I mean not the principle which I am sure applies at least in part for some.

    2. Anonymous says:

      Hi Midge

      Well until they need a 2 trillion dollar coin etc…! Or 3,4 5 …
      Seignorage is a powerful and valuable tool but within limits.

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