This from Martin:

If you’re an emerging-markets investor, and you happened to peruse the study that the Institute for International Finance released this week, you must’ve experienced alarm – if not panic. The IIF expects the inflow of private funds into these markets to plunge to only $165 billion this year – an amount that’s just 18% of the $929 billion that flowed into these very same markets in 2007.

For investors, the message is clear: We’d better concentrate on those emerging markets whose inhabitants have hefty piggybanks of their own.

The details of the investment slowdown are as alarming as the headline. Bank loans to emerging markets will decline from an inflow of $165 billion to a net outflow of $61 billion. Private non-bank debt investment will decline from $125 billion to $31 billion, and even official flows will decline from $41 billion to $29 billion.

Net portfolio equity investment will remain negative, though the outflow will be only $3 billion compared to 2008’s $89 billion. Only direct foreign investment will increase, rising 12% from 2008 to $195 billion.

In terms of regions, emerging Europe will suffer worst, with inflows plummeting from 13% of regional gross domestic product (GDP) in 2007 to just 1% in 2009. Latin America will also suffer, with inflows dropping from 11% of regional GDP to 3%.

Overall, inflows to emerging markets will drop by 5.8% of emerging market GDP between 2007 and 2009 – almost double the declines of the late 1990s crisis (3.7% of emerging market GDP) and early 1980s (3.2%). Emerging market cash flows will also be affected by the need to repay $223 billion of private market debt this year.

This will cause a reordering of the economic pecking order in the emerging markets.

From 2003 to 2007, the availability of natural resources and/or cheap labor was more important than high foreign reserves or a big domestic savings base, so Argentina (natural resources) and emerging Europe (cheap labor, relative to the EU average) did well.

In 2009, access to capital will be more critical than either of those other strengths. Countries without a large domestic savings base, or with substantial balance-of-payments deficits, or with low foreign exchange reserves, are likely to suffer badly.

Many emerging Europe countries have balance of payments deficits exceeding 10% of GDP so will suffer badly. Within that region, the Baltic states – fairly uncorrupt and friendly to foreign investment – will do much better than Romania and Bulgaria, which are both corrupt and xenophobic.

In Latin America, Brazil has an excellent domestic savings base, which it has been nurtured by policies that keep interest rates much higher than the rate of inflation. It is also quite friendly to foreign direct investment. Hence, in spite of its high foreign debt, Brazil should do fine.

Conversely, Mexico has a lower domestic savings base, relies heavily on remittances from Mexicans in the United States (which have declined sharply) and is quite hostile to foreign investment, particularly in the energy sector. Hence it is likely to have a tough year.

In Asia, China – with huge domestic savings, $1.95 trillion in foreign exchange reserves, and low foreign borrowing – will do fine. Conversely, India’s high domestic savings are offset by a profligate government, which runs a wasteful deficit of more than 10% of GDP. Hence India is quite reliant on foreign borrowing, and is likely to have problems.

Which ETFs the Pros are Buying

For investors, the message is clear. Our emerging markets investments must be concentrated in countries that will not be badly affected by the decline in foreign capital inflows, preferably where domestic savers have piggybanks that are large enough to fund expansion locally.

In particular, without delving into particular stocks, the following country-specific exchange traded funds (ETFs) are worth looking at:

• The iShares MSCI Brazil Index (EWZ) has net assets of $3.4 billion, a Price/Earnings (P/E) ratio of 7.0, and a dividend yield of 6%. Money Morning Contributing Editor Horacio Marquez recently recommended this Brazilian ETF in this weekly “Buy, Sell or Hold” series.
• The iShares MSCI Chile investable Index (ECH) has net assets of only $112 million and a P/E of 13. However, Chile is interesting because it built up a reserve fund of $21 billion (12% of GDP) during the years when copper prices were high – it is thus not dependent on foreign-fund inflows.
• The iShares FTSE/Xinhua China 25 Index (FXI) invests in the 25 largest Chinese companies. Net assets are $5.9 billion, its P/E ratio 10, and its yield 2.7%.
• The iShares MSCI Taiwan Index (EWT) has net assets of $1.3 billion, a P/E of 9 and a yield of 8%. Taiwan is highly liquid, with large reserves, a high savings rate and almost no foreign debt
• The iShares MSCI Singapore Index (EWS) has net assets of $800 million, a P/E of 9 and a yield of 8%. Like Taiwan, Singapore is highly liquid, with large foreign exchange reserves and little debt. Taiwanese and Singapore companies may indeed benefit from the liquidity crunch by finding attractive investment opportunities in regional cash-short emerging markets with high growth potential, such as Vietnam.

Source: The Five Most Promising Emerging Market ETFs for 2009

Over the past decade, inflation has been tamed, with an operationally independent central bank keeping it below 10% for almost all of the past decade, compared with 2,500% in 1993. Growth is running at 4%-5% a year, external debt has declined dramatically, commodity exports are underpinning large trade surpluses, and foreign reserves have ballooned to $200bn. All this makes Brazil far less vulnerable to global crises.

And the country has just received a “strong vote of confidence” from ratings agency Standard & Poor’s (S&P), says Economist.com. S&P awarded Brazil’s foreign-currency-denominated debt investment-grade status. It claims Brazil’s pragmatic policies have created a “sounder foundation for economic growth and fiscal improvement over the past five years that should continue”.

The upgrade, which in due course seems likely to be followed by upgrades from the other major ratings agencies, Moody’s and Fitch, will gradually lower the cost of capital in Brazil – as borrowing costs fall with a better credit rating and money flows into the country – boosting growth prospects.

International funds that are barred from buying sub-investment-grade bonds will now be eyeing up Brazil and interest among global equity investors should mount amid optimism over future growth; with new fixed-income and equity flows and more foreign direct investment on the cards, the move is a “strong long-term positive for Brazil’s financial markets”, says Citigroup’s Geoffrey Dennis. The stockmarket has gained over 8% since the upgrade and the Bovespa index is at a new record of around 70,000; it has risen sevenfold since 2002.

There is ample scope for further gains in the long-term. Brazil is ideally placed to cash in on the secular commodities boom, given its own oil, a thriving ethanol production sector – thanks to its sugar cane – world-beating iron-ore production and “one of the most efficient agricultural sectors in the developing world”, says Stephen Foley in The Independent.

Bulls also point to the fact that exports comprise just 14% of GDP, shielding Brazil from “changes in the export environment”, as Daiwa puts it; growth has been led by domestic demand as job and household income growth has fuelled consumption among the expanding middle class. Retail sales were up by an annual 12.2% in February.

But now short-term interest rates are rising, says Dennis. In April, the central bank hiked rates by 0.5% to 11.75%, and with growth strong, inflation back to 4.7% and inflation expectations rising steadily, rates may have to go higher than the 13% economists are pencilling in. He also points to “notably rich valuations”, with the market’s forward p/e of 12.4 42% above the historical average and the price to book value ratio at a record 3.5.

Moreover, as the past year has shown, Brazil will not be immune to a likely relapse in global markets amid fears over the American and global economies – note that the Bovespa index is highly cyclical, with the energy and materials sectors comprising 60% of the index. There will probably be better long-term buying opportunities in the months ahead.

Source: Brazil Is Well Placed for Triumph, But Wait for a Better Time to Jump In