An emerging market is a term often used to describe a developing country’s economy. As the country’s economy grows, it is also getting increasingly involved in global markets. Emerging market economies share some of the features of a developed country or market.
One of the common traits of emerging market economies is that as it develops its connection with the global economy increases. Therefore, the liquidity within their own financial markets increases. This means that stocks of those countries become more widely traded, and so do bonds both corporate and sovereign. These changes lead to an increase in trading between the country, and other countries. As an emerging economy continues to grow, it is able to attract foreign investment, that foster the development of their regulatory entities
India, Mexico, Russia, Pakistan, Saudi Arabia, China, and Brazil are current examples of developing market economies.
What characteristics does an emerging market have?
As we have seen, emerging market countries are defined by their growing economy, however, they do not have all of the features of a developed market. A few characteristics define emerging market countries:
A defining factor of an emerging market is a growing economy. A growing economy requires capital, and growth attracts foreign investors. Because they lack certain things that are common in developed economies, the level of risk when investing in emerging markets is higher. These are the most defining features of an emerging market.
Average salaries are lower
Due to the high growth but relatively low cost of living, salaries in emerging markets tend to be lower. This also helps to fuel its growth, as investors see this as a beneficial point to start a company in one of these markets.
Volatile financial markets
Due to the inherently higher risk, emerging markets have more volatility in their markets. Both the stock market and debt market are therefore much more volatile. They also have lower trading volumes, when compared with developed countries. The currency of the country might also fluctuate far more than well-known currencies like the Euro and Dollar.
Potential investment returns are higher
When compared with developed countries, most investment opportunities in emerging markets have a better-expected return. Another aspect that is common is that business valuations are lower, representing the increased risk. Therefore emerging markets are a great place to look for undervalued stocks.
Risks of an emerging market
This is perhaps the most significant differentiating factor. The political system is fairly different in emerging markets and developed markets. Government intervention in emerging markets is also far more common than in developed economies. This constitutes a risk that investors should keep in mind. The government’s involvement in the economy is also something to consider. Some emerging countries might be too dependent on state-run enterprises that might operate in a very distinct way than in developed countries.
Emerging markets often have cultures that are not so receptive to a market economy. This poses a risk, and it is also highly relatable to political risks. A shift in political orientation within the country could pose a risk. Cultural understanding of how business regulations, and how to conduct business could also negatively impact investors.
Due to the stark differences in culture towards financial markets, and the government there are instability risks that should be considered. Although this is by far the least likely risk to be faced by an investor in emerging markets it is still a possibility that should be accounted for.
The market structure is also completely different in an emerging market and a developed market. For this reason, legislation might be entirely different. Legal institutions might also operate in a different way, and might not have the outreach as a developed market. An example is regulators in financial markets might have different impositions, and might not be able to protect investors in the same way that developed countries do.
This is a common feature of emerging market economies and constitutes one more risk that investors should consider. Although this can be hedged, there are costs associated with that. Additionally, the more unstable a currency is, the more the cost of hedging will be.
Difficult to conduct investments
Emerging markets might limit access to certain types of investors. Foreign retail investors might not even be able to trade the local stock market. This is also reflected in the liquidity of the overall financial markets in the region.
Lack of legislation and regulations
Another risk investors in emerging markets might face is the lack of specific legislation and regulations that could negatively impact their investments. Regulation standards might also not be as demanding as developed countries.
Lower market efficiency
Due to some of the risks mentioned above, the local financial markets might not be efficient. Although this is clearly a risk, it is also an opportunity for the right investors. As market inefficiencies create value investment opportunities.
Lower accounting standards
Accounting standards are also a major difference between developed and emerging markets. For that reason, investors should be knowledgeable of the local accounting standards used, and how they can impact their investments.
How to know if an emerging market is attractive?
There are a few ways to understand if an emerging market should be a good place to invest.
Due to the high level of economic growth, it is important to invest in emerging markets that are able to embrace change. As the country develops, it is important to be dynamic and adapt fast. If a country is not able to do this, it could pose several risks to your capital. Embracing reforms, and the creation of new institutions that promote economic growth will be a noticeable factor to look for.
How the government reacts to this fast-paced economic change is also a determining factor to invest in an emerging market. Look for countries where the government is embracing change, and implementing measures to further support the continued economic growth. Try to understand what policies are in place to benefit foreign investors like:
- Export-led growth
- Growing imports
- Investments in public infrastructure
- Legislative and regulatory changes
- Accommodative measures to attract foreign capital
Why should investors seek to diversify in an emerging market?
Emerging markets offer certainly one of the most asymmetric investment opportunities. Due to the higher level of risk, and scarce foreign investment they are the perfect place to find investments with some of the best potential returns. However, investors should not forget that the high potential return also entails a higher risk level than in developed nations. For that reason, it is important to diversify across emerging and developed markets.
How are emerging market countries classified?
Different entities classify countries as emerging markets based on three main factors:
- Income levels,
- Financial system quality
- Growth rates
For instance, the International Monetary Fund (IMF) defines 23 nations as emerging markets. Morgan Stanley on the other hand counts 24 countries as emerging markets. Standard and Poor's defines 23 nations as developing markets. Therefore the number of emerging market nations varies across the entities that are describing this.
Image source: ETF