The fact that emerging markets in Asia, Africa and Middle East have managed to stave off the worst effects of the global credit crunch for over a year has impressed investors enough to rethink their fund strategies and shift large amounts of cash to countries which just five years ago they would have been reluctant to touch.

Fund managers feel that many developing countries have shaken off their legacy of debt and that since they now have current account surpluses, they are therefore deemed to be of investment-grade quality. Corporate governance is also improving and many companies are adding shareholder value by offering steady dividend payouts. More importantly, proponents of emerging market investing claim stocks are under-researched, under invested and, therefore, full of untapped potential. Just look at the figures in one emerging market – the Gulf States. The value of rights issues by Gulf-based companies has jumped to a record $15.76bn over the last year, a 242 percent increase on the previous year.

Growth rates for the regions also sit well. The IMF predicts an average 6.8 percent growth each year for the next five years for developing markets. While that may be some way short of the double-digit growth enjoyed to date, it still outstrips the 2.7 percent forecasted for developed markets.

Furthermore, the Investment Management Association (IMA) Global Emerging Markets sector, which consists of 33 funds primarily invested in Latin America, Emerging Europe, the Middle East, Africa and Asia, has demonstrated the capacity for developing markets to outperform.

Over three years on a cumulative basis to 30 June the average return was 80.1 percent, according to Morningstar, the fund research firm. This compares with the Global Growth sector, which returned just 25.5 percent. Given that most analysts agree that the credit crunch is now beginning to hit emerging markets, that figure is likely to have dropped. But economists insist that developing and frontier markets still have plenty to offer for investors.

Foundations
Real estate is a particular favourite. According to Real Capital Analytics (RCA), a research and consulting firm, the volume of real estate deals in the industrialised world fell 54 percent in the first quarter of 2008 compared with a year ago. But at the same time, the number of transactions in emerging markets jumped 43 percent in the first quarter. And the big investors are jumping in. A Citigroup survey of 50 major pension funds in the US and Europe found that portfolio managers want to commit some $370bn to real estate over the next three years, in spite of the slowdown in their domestic markets.

Big chunks of that money are beginning to flow into countries such as China, India, Russia and the emerging economies of eastern Europe. Charles Schwab's $228m Global Real Estate Fund made its first foray into emerging markets in March. Although China is the emerging real estate giant, it is hardly alone. India saw property sales volume jump 210 percent in the first quarter over the first three months of last year, making it the world's fastest growing real estate market. Analysts at Morgan Stanley are extremely upbeat that they expect a secular boom in emerging market property over the next ten years. They think developing nations will spend a massive $22,000bn on core infrastructure projects during the period. Half of that, about $11,000bn, will go towards construction.

The theme of infrastructure spending in emerging markets is not new and many investors have been exploring this opportunity for several years.

By 2015, almost half the population of emerging markets (nearly three quarters of the world's urban population) will live in urban areas, thus accelerating demand for power generation, transportation, and sanitation. This may slow in the current credit environment but will ultimately come through.

Working on the frontline
Frontier markets are also looking particularly attractive. These are popular with investors because they are largely uncorrelated with global markets, with other emerging markets, and with each other, which means that they are less likely to suffer from economic wobbles when other countries' stock markets take a tumble. EPFR Global, a Boston-based company that tracks international fund flows, says that so far this year, inflows into the Middle East and North Africa have been competitive. The turnaround is due to economic reforms, a better banking climate and a growing credit sector.

In the past, Africa has attracted more retail than institutional investors as the latter have shied away from some of the continent's small and illiquid stock markets. But now that the credit crunch has dented confidence in the world's best-regarded exchanges, attitudes to frontier markets are beginning to change. Swiss banking group Julius Baer, which rolled out its Northern Africa Fund last September and recently launched it in the UK, has seen the fund grow from just $15m at the beginning of the year to $170m, with investment largely coming from the institutional side.

Up until September this year, Africa's main economies had remained largely unaffected by the financial crisis. For example, Nigeria has been largely immune to the short-term volatility roiling more established emerging markets. But some cracks are beginning to show. Analysts warn that the turmoil on Wall Street could pose longer-term risks to prospects for a recovery in sub-Saharan Africa's second biggest stock exchange if it fuels a global slowdown that saps prices for oil exports.
Nigeria enjoyed one of the strongest performances of any emerging market last year on the back of surging demand for banking stocks following a successful consolidation exercise. Flush with cash, banks such as United Bank for Africa, First Bank and Access Bank used the funds to expand across the continent. But growing global concerns over bank valuations helped trigger a steep correction in Lagos – where banks make up about two-thirds of the total market capitalisation of $85bn. As a consequence, the NSE All Share Index has lost 31.44 percent since March 5, according to Afri-Finance, the advisory firm.

Although foreign investors have played a role in influencing sentiment in Nigeria, last year they accounted for only about 12 percent of the value of transactions, limiting their potential to cause havoc with a hasty retreat. Nigerian banks are, however, concerned that the credit crunch will make it harder to secure credit lines in the US and Europe for trade finance. Another worry is how banks will manage their losses in the local market. Much of last year's gains were driven by banks lending money for share purchases that have soured.

Asia is also showing signs of weakening. The South Korean won has fallen almost 30 percent this year to become the worst performing important currency and South Korea is expected to suffer its first annual current account deficit since the 1997-98 Asian financial crisis.

On November 1, the Reserve Bank of India (RBI) took emergency action to pump liquidity into the local banking system amid mounting concerns that the global financial crisis will cut significantly India's economic growth.

The threat of a slowdown is also being felt by India's richest 10 billionaires, who control some of the country's biggest companies and have suffered $206.5bn in paper losses this year. With foreign investors helping drive down Mumbai's main stock market index by 52 percent since January, the valuations of their listed companies have been battered.

The RBI cut the repo rate 50 basis points to 7.5 percent, lowering the key short-term interest rate for the second time in two weeks. It also reduced the cash reserve ratio, the amount of money banks have to hold with the central bank, 100 basis points to 5.5 percent, releasing about $8.1bn into the banking system. The measures to protect Asia's third largest economy followed rate cuts by the central banks of Japan and China a week earlier.

Tycoon spirit
While the stock market tumble has affected tycoons across most sectors of the economy, the biggest loser has been Mukesh Ambani, India's richest man, whose companies Reliance Industries and Reliance Petroleum lost $53.1bn in value, exacerbated by the drop in commodity prices. His brother Anil Ambani, India's second richest person, has seen $52bn wiped off the valuations of his telecom, power, financial services and infrastructure groups.

The $200bn in paper losses by India's super-rich – which is close to the GDP of neighbouring Bangladesh – is a clear indicator of how badly the exodus of foreign investors has hit the equity markets. Foreign institutions have made net sales of $8bn worth of stocks since the beginning of the year compared to the net purchase of $15bn the previous year, said the Securities and Exchange Board of India, the market regulator. Furthermore, the Morgan Stanley Capital International (MSCI) Emerging Markets index, designed to measure equity market performance in global emerging markets, has fallen by well over 50 percent since the start of the year, compared with about 35 percent for the Dow Jones Industrial Average.

Nevertheless, emerging market sovereign bonds might just turn out to be the safest place for investors' money. Ashmore Investment Management, which manages $32bn of emerging market securities, says that there are two main reasons for this. The first is the weakness of US finances, and the second is the strength of emerging market balance sheets.

“People are saying this downturn is terrible for emerging markets,” says Jerome Booth, Head of Research at Ashmore. “But they are forgetting that emerging economies are the only ones with surpluses.”

Emerging market economies have accumulated reserves and other savings pools of $9,000bn, compared with less than $100bn in the US and the UK combined, and are in far better shape to weather a severe downturn.

In addition, whereas some western economies are expected to grow at one percent or less next year, Chinese growth will “moderate” to nine percent and India's economy will slow to a respectable six percent growth rate, investors point out.

Emerging markets already command 30 percent of the world's gross domestic product and this will rise to 50 percent in 15 years, Ashmore believes.

In other words, capital is likely to flow to these countries in future years, strengthening their currencies and making their bonds even more attractive. As a result, institutional investors still have a keen appetite for emerging markets in spite of volatility and heavy falls across stock exchanges this year. Already, three-quarters of northern European investors are planning to raise exposure to emerging markets equities over the next three years, according to a survey by Nomura Asset Management UK.

“Many institutional investors are looking at emerging markets as a long-term strategic investment,” said David da Silva, who runs Nomura's regional emerging market strategy. “These countries in general continue to grow faster than their developed counterparts, and although they are facing difficulties in the current climate, high savings rates and strong fiscal positions remain a feature of many emerging markets,” he added.

Out of the 20 institutions surveyed, a quarter will raise their emerging market exposure between four percent to 10 percent, while the rest have more modest plans of increasing exposure by up to four percent.

Where the money is
Emerging markets are now the largest economic bloc and provide a stimulus to the global economy. Prior to recent events, emerging market economies were expected to deliver more than 60 percent of all global growth in 2008, with the funding of this growth not dependent on foreign sources of capital.

While the figures may have changed, the fact remains that emerging markets are funding the developed world.

Although no one denies the importance of the US in the global trade context, the trend has clearly been in favour of emerging markets. Emerging countries are trading more with each other and less with the US as demand in emerging economies booms. Intra-emerging markets exports have risen significantly since 2000, while exports to the US have decreased.

Fewer big emerging market countries are heavily dependent on overseas investors than in previous episodes and their public finances, in particular, are in much better shape. A decade after the Asian and Russian financial crises, emerging Asian countries have maintained current account surpluses – last year averaging five percent of gross domestic product – and built up hefty official foreign exchange reserves.

Michel Camdessus, the former managing director of the IMF, perhaps sums up the mood of many investors who still look to emerging markets – and their infrastructure projects – as a safe haven. In a speech in Manila in October, Mr Camdessus forecast that “thanks to the dynamism of Asia, the global economy will avoid recession”.