EM debt can go mainstream, says Jim O’Neill

The chairman of Goldman Sachs Asset Management and creator of the Bric theme, Jim O’Neill, discusses changing investors' mindset regarding safe-haven assets and accessing emerging markets.
EM debt can go mainstream, says Jim O’Neill

Jim O’Neill is best known for creating the idea of the Brics – that Brazil, Russia, India and China will overtake the US and Western Europe in leading world economic growth, thanks to population size, productivity and urbanisation. He penned that as chief economist at Goldman Sachs in 2000. In 2009 he was named chairman of Goldman Sachs Asset Management.

At the end of your new book explaining the Bric story and the concept of the ‘next 11’ growth markets*, you mention that investors need to rethink how they benchmark assets, but don’t go into detail. So how do investors rethink benchmarks?
When I became chairman of GSAM 15 months ago, I was of the opinion that market-capitalisation benchmarking was for the birds, and that people should move to GDP-weighted benchmarking.

Beyond free-float issues, market-cap benchmarks underestimate the importance of the Brics and other emerging markets. A GDP-weighted benchmark sort of anticipates where market caps will be in the future – especially if countries like China and India implement the right reforms as they’ve discussed.

I have come to realise that I was a bit naïve. GDP-weighted benchmarks run the risk of exaggerating allocations in the opposite direction. They also miss out on the phenomenon of multinationals in the West, such as Nestle or BMW, getting more revenues and profits from their own emerging-market exposures.

So it’s quite tricky. And that’s just the equities world.

What’s been your practical response to this puzzle?
Our quant team has developed a new, rules-based investment approach called Equity 3.0. It symbolises how a global investor can think, by marrying the dilemma between the two benchmarking approaches, along with two other attributes. First it restrains overall volatility, and second it includes a valuation parameter, mostly based around price-to-book. It nearly doubles the emerging-market exposure you’d have from a market-cap weighted benchmark but it doesn’t add risk at the portfolio level.

What about fixed income: how should investors re-conceptualise their global allocations?
We are now turning our attention to this. It may well turn out that GDP-weighted benchmarks are even more valid in the fixed-income world, especially in light of the European sovereign-debt crisis.

If you take the original Maastricht Treaty criteria for admission to the European Monetary Union, such as having no more than 60% of government debt-to-GDP or a maximum 3% deficit-to-GDP ratio, only three members of the eurozone would meet it: Finland, Slovenia and Estonia. In the wider Western world I think only Australia, Sweden and maybe Canada would also be eligible.

But six growth economies could walk in there tomorrow. So why are investors looking at global debt benchmarks that are based on the level of government bond issuance?

I think the growth of the renminbi’s role in foreign exchange will be important to the asset-management world, particularly fixed income.

Picking a theoretical benchmark is one thing; actually being able to get access to markets like China’s or India’s is another.
That’s true, and our Equity 3.0 benchmark has deliberate constraints to reflect this.

Are you actually seeing client flows into the Equity 3.0 framework?
The asset-management world moves slowly. People need to do their research and due diligence. So the amount of money right now is small. But the frequency and intensity of discussion is rising dramatically. Just this week my colleagues are in Asia, talking about this with major investors in Japan, Singapore and Hong Kong.

What do you make of the notion of a ‘safe haven’, given the investment world’s apparent ‘flight to quality’ in the form of US Treasuries and German bunds?
We continue to see significant inflows to emerging-market debt products. Since the summer of 2011, we have seen two trends. One is the shift out of equities to fixed income. The second is within fixed income, out of peripheral Europe – some of that is going to EMD, but more is also going to Treasuries and bunds.

These are ‘safe havens’ because of liquidity, not because of superior macroeconomics. What explains this apparent lack of logic?
I think it’s sheer, classic domestic investor bias. I speak nowadays with a lot of long-only investors, and it is remarkable how conservative they are, particularly US-based pension funds and insurance companies.

A lot of that is also driven by regulation.
I’d say it’s exaggerated by regulation. Corporate pension funds are fighting to finance shortfalls, but they have also concluded they cannot afford any chance of a 2008-style risk. So as low as yields on Treasuries have fallen, at the margin, these investors are being encouraged to shift more assets into bonds. That’s why corporate bonds are doing so well. They at least offer some kind of yield pick-up, but they are also domestic and perceived as safe.

What does EMD as an asset class need to see happen in order to attract more liquidity and become accepted as a smarter investment for long-only clients?
The development of the renminbi is important, especially if it joins the SDR basket by 2015. [Special drawing rights] are a non-used currency, they’re an accounting tool used by the IMF, but symbolically they are at the core of the world’s financial markets. There’s only four currencies in it [dollar, euro, yen, sterling].

Last December the G20 made a statement that got lost in the noise, but it seems to show consensus that the RMB will join the basket by 2015, pending Beijing’s speed of reform. The rouble could join too. That would be hugely symbolic in this context of influencing investor behaviour.

What else has to happen?
Two things. First, look at what central banks do. For example, the Bank of Korea has just announced it will start to invest some of its surpluses into Chinese equities. If we get more of that sort of thing, it should slowly influence conservative investors in the US and Europe, and maybe Japan too.

The other thing that matters is performance. Now, every year analysts will predict the end to the bull run in US bonds, but that market has been having a bull run for 30 years, the entirety of my career in finance. No one’s been wrong to invest in Treasuries, yet. But when it reverses, and if emerging-market fundamentals remain strong, people will move quickly.

What’s the risk that many emerging or ‘growth’ markets fall into the middle-income trap, and don’t graduate to wealthy, developed status?
I have one piece of advice to policymakers in these countries, and that is: copy Korea. That’s the one market that seems to have really broken out.

The next two years are also going to be critical for China. If China can adjust its GPD growth down to 7.5-8% while keeping inflation under control and moving consumption to occupy a greater share of GDP, it will definitely be on the right path. If it can’t do this, then some of us might have to have a bit of a rethink. And of course, the consequences of this go far beyond China.

A philosophical question: what’s the relationship between political systems and economic success?
I don’t know. That’s why it’s exciting to be in this industry, because we may get a better sense of the answer over the next several years.

The whole reason why I dreamt up the Bric idea 10 years ago was that it seemed to me that we had reached the end-point of Americanisation dominating globalisation. That seems more obvious today, post-2008. The US relied on sophisticated leveraging of international finance to allow America to use the world’s capital, without using any of its own. That has created pain, as we now see, and some form of rebalancing is required.

There’s a view in the West that capitalism is finished. But the likes of China and India are still, on their own timescale, moving to more liberal systems, including capital markets. The Western model, at its core, is the right framework to deliver success.

How would you illustrate that to policymakers in Asia?
It’s tough to see how China could permanently pull off continual growth and wealth creation without further opening its capital markets. The bubble in residential real estate can be explained by the lack of other outlets for that wealth. And the authorities recognise this.

The question for all of us is how to reach that happy balance. I’ll give you an example from my own country, the UK. These days few want to admit to being a banker. But the debate over compensation and more state involvement could turn out okay. Maybe there is a role for state development banks for priority industries in a country like the UK. But this sort of thinking goes against the whole grain of the post-Thatcher/Reagan era. I don’t know what is the right balance. That’s the excitement of being in this industry in this decade, because I think we’re going to come closer to some answers.

*“The growth map: Economic opportunity in the Brics and beyond”, by Jim O’Neill, published by Portfolio Penguin, 2011.

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