Emerging markets stumbled from one crisis to another during the 1980s and 1990s, but their fortunes appeared to change for the better during the early years of the new millennium. A dollar invested in emerging market equities at the start of 2003 grew to $4.78 by the end of 2010, a return of 21.5 per cent a year, as compared with $2.02 or 9 per cent a year for a dollar invested in world equities.

Investment commentators hailed the arrival of a “golden age” for emerging market equities, but the outperformance did not last long.

Stocks in these markets have been nothing short of a major disappointment over the past three years; returns have trailed developed market equities by 11 percentage points a year since the end of 2010, and almost 24 percentage points over the last year alone. Has the emerging market story come to a premature end once again or is this just a cyclical blip?

The upturn in emerging markets’ fortunes got under way in 2003 and was driven by some unusually favourable developments that combined to produce growth rates that were well ahead of historical experience.

The tailwinds included: debt-fuelled consumption in advanced economies and the accompanying increase in the demand for emerging market exports; China’s integration into the global economy and the associated commodity super-cycle; the extensive availability of cheap external financing; and last but not least the widespread adoption of macroeconomic stabilisation policies.

Emerging market economies grew at an annualised rate of 7.5 per cent during the five-year period that immediately preceded the global financial crisis – more than double the growth performance registered during the 1980s and 1990s.

That robust performance saw the growth differential between emerging market economies and advanced economies jump from less than 1 per cent during the 1980s and 1990s to an unprecedented 5 percentage points in the pre-crisis period.

The astonishing emerging market growth leading up to the global financial crisis was heavily dependent on buoyant consumer demand in advanced economies, primarily the US. In very simple terms, China invested heavily in the infrastructure required to support its export sector, and benefitted handsomely from the West's debt-fuelled consumption.

Meanwhile other emerging market economies focused on the commodities and semi-finished goods required to feed China's vibrant, export machine.

Dollar reserves
The trade surpluses arising from emerging markets' export-oriented growth models were recycled into low-yielding US assets. The accumulation of dollar reserves resisted the upward pressure on emerging market exchange rates and kept exports competitive. Additionally, long-term interest rates were pushed lower in the US, and the reduction in borrowing costs – in tandem with the resulting increase in house prices – allowed for the debt-fuelled consumption of cheap emerging market imports.

The export-led growth models were accompanied by the adoption of macroeconomic stabilisation policies across much of the emerging market world.

Inflation was largely tamed with the median emerging market inflation rate declining from almost 12 per cent by the mid-1990s to just 4 per cent in 2002.

Further, public finances were brought under control with public-sector debt ratios dropping below 50 per cent by 2003 and primary budgetary positions turning to surplus by 2005.

The increased credibility afforded by a sound policy framework allowed emerging market economies to deepen their local-currency bond markets, and lengthen their maturity structures. The vast improvement in the emerging market balance sheet meant that vulnerability to financial crisis was greatly reduced.

The reduced dependence on external debt, in concert with the massive increase in foreign exchange reserves, saw the emerging market world become net creditors to the rest of the world as regards debt contracts. Thus, a currency depreciation of the sort typical of previous crises would lead to an improved – and not a life-threatening – external position. Further, the higher prevalence of longer-term debt lowered the risk of a rollover crisis.

In this context it is not surprising that the emerging market economies weathered the global financial crisis well, insofar as the external shock did not translate to full-blown domestic crises.

The collapse in international trade did result in a 6 percentage point drop in growth rates between 2007 and 2009, but the much-improved emerging market balance sheet allowed for aggressive monetary easing and sizable fiscal stimulus programmes that resulted in both a swift and robust recovery.

Emerging market growth jumped to 8 per cent in 2010, and the differential with advanced economies reached 6 per cent as the Western world continued to struggle.

The exceptional performance was driven primarily by China, which implemented a massive stimulus programme that unleashed a debt-fuelled investment boom. The aggressive crisis response precipitated a turnaround in commodity prices and a surge in imports from other emerging markets in 2010.

The initial growth spurt faded, however, and it became increasingly clear that the export-oriented growth model was broken. World exports grew at twice the rate of global GDP during the 2003/07 period, and emerging market economies benefitted accordingly. But the end of debt-fuelled consumption in the West saw growth in world exports slow to just 1.5 per cent a year over the past five years – marginally below world output growth.

Growth models
Emerging market economies have struggled to find new growth models, and as a result have failed to regain their momentum. Growth rates dropped below 5 per cent in each of the past two years, and the differential with developed economies has fallen to the lowest level in more than a decade.

Efforts to boost economic growth have proved fleeting and detrimental to long-term growth. In particular, negative real interest rates across the emerging market world in recent years prompted a credit-driven investment boom, where much of the capital was unproductively employed. In addition, corporate sector debt ratios have surged to dangerous levels, and several reliable leading indicators of financial crisis are at levels that have preceded economic dislocation in the past.

Sluggish growth and high debt ratios mean the romance is over for now.