(Sukuk.net - Arab News) The first anniversary of the credit crunch as a result of dodgy investments in collateralized debt packages backed by US subprime mortgages which forced banks to write-off billions of dollars of debts, fell last week, and for a change the prospects of investing in emerging markets has increased substantially.

The reason for this is because the impact of the credit crunch on emerging markets has been limited, although it varies from asset class to asset class, such as public equity, private equity, US dollar debt or local currency debt.

According to Nasser Al-Shaali, CEO of the DIFC Authority, for instance, "The historical relationship between the Gulf Cooperation Council (GCC) with the Western world — whether security or trade — is changing fundamentally. The GCC economies are more diversified and are undergoing tremendous change. But, because of this historical relationship, they tend to be bifurcated into what is happening in the systemic cycles of the US and Europe. The only impact of the credit crunch in the short-term that we have noticed is that financing has become a bit more expensive. We have not seen people or institutions writing off billions of dollars off their balance sheets."

Al-Shaali believes that Islamic finance uniquely and importantly has some lessons for the conventional sector which he stresses needs to be to be articulated to the wider world. "We have the prohibition on ambiguous trading (Gharar) which would proscribe the constant repackaging of those risks of subprime structures — one derivative on top of another derivative."

Tadashi Maeda, a senior executive of the Japan Bank for International Cooperation, similarly stresses, "The subprime mortgage crisis has had a minimal effect on bond issuance and other debt market instruments out of Japan"

However, Jerome Booth, a Senior Executive and research director at Ashmore Investment Management Ltd., which specializes in emerging markets, stresses that "for the conservative investor though, defense against further risk comes first. This argues for local currency-denominated emerging debt, arguably the best hedge there is against dollar weakness."

There has been a build up of official reserves of emerging markets especially China, Saudi Arabia, other GCC countries, India, brazil etc over the last decade, which together with private investments, have been invested in US assets. China and Saudi Arabia, for instance are the largest holders of US dollar reserves. This flow, Booth stresses, has enabled and funded a negative personal savings rate in the US. The emerging countries have been net exporters of capital for the best part of a decade. But this trend is now set to reverse.

The first place to invest, he explains, "as a hedge against widespread (as opposed to Euro-focussed) dollar weakness, is thus emerging local currency debt. Emerging private equity and corporate high yield also seem particularly attractive right now. With dollar sovereign emerging debt displaying supportive medium term fundamentals, there are strong arguments for a number of emerging asset classes. Investing in a variety of them should be a central consideration for strategic asset allocation in the wake of the credit crunch."

The crucial question remains whether the rest of the world led by China, Saudi Arabia and the like, will be willing to finance the US current account deficit to the same degree as before. The deficit currently is about $750 billion a year. The recent improvement of US exports (due mostly to non-oil commodities) however has been offset by a rise in oil imports. Even the International Monetary Fund (IMF) is not confident of a permanent reduction in the deficit in the near-term especially in a presidential election year.

The irony is that foreign investments in the US, especially in treasuries are, on the whole not that profitable. The Chinese for instance are losing billions of dollars a year on their investments, a scenario they are prepared to put up with for the moment. This situation is what is financing and sustaining the US deficit.

So far most dollar weakness has been against the euro. Conversely, appreciation against the dollar is the obvious policy response, together with higher domestic interest rates, for a number of emerging central banks looking to cool over-heating economies.

The fight against emerging market inflation, says Jerome Booth, has already started and whilst there are still skeptics, he strongly believes that "the likelihood is that by and large this fight will be successful. Emerging countries have not spent a decade improving fiscal and monetary policy to throw it all away again. The response, necessarily involving substantial currency appreciation as well as interest rate tightening, has barely started."

The credit crunch has thrown considerable doubt on traditional asset allocation choices. Emerging asset classes have shown great resilience, and with the continuing slowdown in the financial and real estate sectors in the developed world, it is perhaps important to re-think asset allocation strategies. This could be the biggest impact of the credit crunch.

Developed markets are in many cases more risky — a thought which would have been unimaginable only a year ago. The biggest medium term impact may thus be an "erosion of the home investment bias in the developed world and the anti-home bias in the developing world", according to Booth. Emerging markets are no longer peripheral.

They comprise 85 per cent of the world's population. They have the largest physical resources, and the highest actual and potential growth rates and return on capital. They may also represent 50 percent of global gross domestic product (GDP), using market prices, in fifteen years. Using purchasing power parity they already represent about 50 percent of global GDP.

This means that emerging markets should by then attract 50 percent of asset allocation, with a 35 percent allocation now eminently prudent. Some large institutional investors are already 30-35 percent invested in emerging markets. Booth argues in his latest report on the first anniversary of the impact of the credit crunch that there are indeed as many potential asset classes in emerging markets as there are in developed countries, and many are uncorrelated to each other.

"An at least partial substitution from US Treasuries and other G-7 sovereign bonds to non-G-7 sovereign debt, denominated both in dollars and local currencies, can both significantly reduce risk and increase return. Within credit allocations emerging market corporate debt may look much more attractive than European or US high yield, and away from the credit crunch crash site," he concludes.

[END] ` omar1.1 mfn