Lesson 8:

Emerging Markets and Gold Part 1

Lesson 8:

Emerging Markets and Gold Part 1

It’s often heard that there is incredible demand for gold from emerging markets. But what are these emerging markets? How are they different from developed markets and one another? And which ones are the most important to gold? This lesson and Part II takes a look at these and other questions.

What is meant by an Emerging Market country?

The definition and even naming of what is an emerging market economy (EME) remains disputed and controversial. And in addition, highly political with significant economic repercussions. Indeed, once a country is upgraded to an emerging market status it stands to gain from the USD10+ trillion already invested in countries categorised as such.

Emerging markets (EM) are defined by their progress relative to developed markets. So, let’s look at one way a developed country can be defined:

– GDP per capita above USD12,000
– Low infant mortality
– Average life expectancy above 70 years
– High living standards
– Highly industrialised
– Liquid and efficient capital markets
– Trusted rule of law
– Political Freedoms
– Freedom of the Press
– High levels of education, healthcare and infrastructure provision
– A middle class or consumer class

There are plenty of other definitions, and certainly different criteria are used. But for our purposes, the above can be useful to help us understand what an EM is.

Emerging markets are therefore assumed to be on the path to a developed country but lack one or more of the above criteria. They are thus in transition. In his book, “The Global Emerging Market: Strategic Management and Economics” (Routledge, London, 2009) Dr. Vladmir Kvint says:

“ An emerging market country is a society transitioning from a dictatorship to a free-market-oriented-economy, with increasing economic freedom, gradual integration with the Global Marketplace and with other members of the GEM (Global Emerging Market), an expanding middle class, improving standards of living, social stability and tolerance, as well as an increase in cooperation with multilateral institutions.”

a table of msci emerging market index

For capital markets and investing, MSCI, the global benchmark for index categorisation, say there are 27 EM.

The IMF, however, argues there are 152, which is pretty much all the non-developed countries, bar a handful of exceptions.

Ashmore, a specialist emerging market financial firm, sums it up clearly:

“Emerging Markets (EM) today are the world’s primary drivers of global growth and wealth accumulation. They cover a dominant share of the world’s population and natural resources, and are called home by the world’s largest reservoir of future consumers.”

The trajectory is strong:

a graph showing emerging markets's share of global GDP according to Ashmore

The MSCI definition helps us define clearly where to focus on in emerging markets by narrowing the definition to just 27 names.

The Importance of Gold in Emerging Markets

Now that we know what an emerging market is, let’s examine the importance of gold for these countries. There are two primary actors within emerging markets, private individuals as consumers of gold and the government central bank. We will start with the latter in this lesson. In Part II we will look at the consumer.

First, however, we need to understand the relationship between EM currencies and the US Dollar. iShares define the vital importance of the US Dollar very succinctly:

“The dollar is the nexus between asset classes. It affects borrowing costs and commodity prices, is a proxy for risk appetite, influences global capital flows and is a central transmission channel for global financial conditions.”

Many emerging market countries borrow in US Dollars. This could be to finance their deficits, or emerging market corporates looking to raise money. When the US Dollar rises against the emerging market currency, it takes more of the emerging market currency to pay back the original loan. Thus, when the US Dollar goes up, paying back the debt becomes more expensive. This has then a knock-on effect on the EME resulting in increased indebtedness and increased defaults and bankruptcies.

On other hand, the appreciation of the US Dollar and other developed market currencies since the Global Financial Crisis in 2008 (due to the extraordinary, expansive monetary policies of QE and other asset purchase schemes) has meant emerging markets have become richer and stronger than ever before. This is because their exchange rates fell nearly 50%, enabling them to become a lot more competitive and thus increase their reserves.

And as they have become more developed, expectations of a new middle class have risen. No longer will defaults, inflation, boom and bust and be tolerated as before. The key was how to maintain this wealth and success without being so dependent on the US Dollar. The answer, at least partially, was to diversify reserves away from the US Dollar. Gold obviously is a key part of this strategy.

In a fascinating interview by the World Gold Council, Dr. Duvvuri Sabbarao, Governor of the Reserve Bank of India during the 2008 financial crisis explains:

“If emerging markets cannot rely on the dollar as a guard against exchange rate instability, then we have to build our own defences. Holding gold within our reserves is an integral part of that self-defence.”

The whole article is a great example of why US Dollar dominance or “hegemony” is a problem for emerging markets. Despite having little to do with the 2008 US Housing catastrophe these countries suffered greatly as US and other Western policymakers instigated actions that led to their own currencies strengthening and then falling once again. This volatility makes it very difficult for emerging market countries to prosper or to have certainty:

“In the immediate aftermath of the crisis, we had to sell dollars to prevent our currency going into freefall. During Quantitative Easing, we had to buy dollars to protect our financial stability. And when the Federal Reserve began to taper QE, exchange rates slumped again and we had to defend ourselves with our reserves. All these events prompted one obvious question – is there an alternative to the dollar?” Subbarao explains. 

This marked a key turning point for emerging markets. From this point, they would look to diversify their reserves away from the US Dollar. With the Euro failing to take off as a real alternative, and the Chinese Yuan also not yet ready, emerging market policymakers decided to invest across a basket of currencies and gold.

Thus, in the past decade, emerging market central banks have been net buyers of gold. And with US and other Western nations monetary policy set to continue along the QE / low rates / negative rates path for the foreseeable future it is easy to see why these emerging markets want to avoid exposures to currencies that are being forcibly devalued by their own governments.

Emerging markets should no longer be called emerging in many cases. They have arrived. And their aggregate power will only rise versus the developed world. And as they become richer and more influential, they will continue to decrease their reliance on the West and on the US Dollar. Buying gold is a key part of this long-term strategy. But it is not only Governments and Central Banks buying gold in emerging markets. Consumers also play a significant role. And it is that role we shall examine in Part II.


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