In a new light

IN HIS recent outline of UK foreign policy, William Hague mentioned that developing countries such as India must be given top priority, and "new and distinctive" relationships must be forged with the likes of Brazil and Chile.

I took this in with mixed feelings. There is a building view that we are leading up to some sort of bubble in Asia, but as always the build-up can be long and painful to those not exposed to the area in question.

It seems that investors are starting to realise that the de-leveraging process in developed markets is likely to go hand in hand with low growth. With their cash in the bank earning precious little, a new view is taken of risks in emerging markets and they are suddenly seen in a new light (despite the prevalence of naysayers).

Once the dust settled in 2009, after the initial liquidity-need driven sales - which often hit smaller cap shares in emerging markets particularly hard - one was able to stand back and look at the starting position countries occupied as they began responding to and working their way out of the crisis.

Some of the key differentials were the indebtedness of the country and its occupants, and the level of interest rates. This hits at the heart of how countries are able to kickstart demand. The usual business cycle at some point involves a revival of the credit cycle.

In emerging countries, this was the case as the government, the people and companies were not that indebted to start with. So while India has a similar government debt to gross domestic product ratio as the US, it had a much higher savings rate and an integral part of its response to the crisis was to encourage lending among small businesses and to pump up infrastructure spend, especially in the rural areas.

In the US, however, there was little scope to kickstart the lending cycle with the consumer heavily indebted. While personal debt levels have come down, all that happened in the past few years is that the US government took on that debt. The starting position is, of course, just as relevant now.

The US has precious little economic firepower left, and will ultimately pay the price for its actions, although it was admirably bold.

Two good examples of the ability to benefit, or not, from the post-crisis lending cycle are Citi Group and Bank of India. In the seven years up to 2010, Bank of India managed to grow its net asset value (NAV) by 23% per annum, while Citi only managed 5%.

Boring savings trump sexy Citi

Up to 2007, a cursory glance at their loan book growth would have shown that they may have been on similar paths. Not that the market recognised that, with Citi trading at a price to book ratio of well over three times around 2003, and Bank of India only at 0.6 times.

Citi was being applauded by the market for growing its book – both by (later apparent) poor lending as well as a large acquisition. The company became more and more complex, with 64 distinct systems in the bank at some point. Bank of India was a lot simpler to understand, but not nearly as exciting.

As these two companies entered the 2008 period, Citi had run out of options, and had built up what turned out to be a really poor quality book. Bank of India had certainly benefited from growth in India, but credit extension was still backed by a large savings rate among the Indian population.

So while the bailout in India meant a resumption of credit extension, Citi had to face large write-offs, shattering the market illusion that its NAV was solid and growing. On top of that, Citi entered a period of no more loan growth.

This picture is reflected in the difference in share price returns over the past seven years: annualised return of 35% for Bank of India, versus -25% for Citi.

So the environment a company operates in has a real impact on its options to respond to pressure and challenges. And while the chase for growth and returns may well push shares in emerging markets higher, ultimately the growth, activity, lending and consumer spending that could take place because of this could put them in a similar risky position to that their counterparts in developed markets faced in 2008.

But, to quote global fund manager at SIM Global Kokkie Kooyman: "The gate is still narrow and compared to what you get on cash, investors are being encouraged to increase exposure to emerging markets, and this could sustain price moves for some time to come."

*Ahern is with SIM Global, a division of Sanlam Investments which travels the world researching listed companies with potential unlocked value.