Key Takeaways
- Emerging market economies are countries in the process of becoming industrialized economies.
- They offer huge potential for growth, but this is tempered by extreme volatility.
- Emerging markets offer large opportunities for foreign investment, but they may expose investors to great risk as well.
- One strategy to reduce risk is to invest in an emerging market fund, which diversifies your investment into a basket of emerging markets, instead of just one.
Definition and Examples of Emerging Markets
Emerging markets are nations that are investing in more productive capacity. They are moving away from theirtraditional economiesthat have relied on agriculture and the export of raw materials. Leaders of developing countries want to create a betterquality of lifefor their people. They are rapidly industrializing and adopting afree marketormixed economy.
Alternate names: Emerging economies, developing countries
A few examples of emerging markets are Brazil, China, India, and Russia.
How Emerging Markets Work
There are five defining characteristics of an emerging market:
- Low income
- Rapid growth
- High volatility
- Currency swings
- High potential returns
These characteristics are found in emerging markets of all sizes.
Low Income Spurs Rapid Growth
The first defining characteristic of emerging markets is that they have lower-than-averageper capitaincome. Low income is the first important criterion because this provides an incentive for the second characteristic, which israpid growth. Leaders of emerging markets are willing to undertake the rapid change to a more industrialized economy to remain in power and to help their people.
Note
The World Bank is moving away from defining "developing" countries, and instead groups countries by income levels, with low-income and lower-middle-income countries having an annual per capita income of $4,095 or less. High-income economies have a per capita income of $12,696.
In 2021, the economic growth of major advanced economies, such as the United States, Germany, and the United Kingdom, was 5.4%. Growth in emerging and developing countries in Asia, such as China, saw their economies grow by more than 8%.
Rapid Change Leads to High Volatility
Rapid social change leads to the third characteristic of emerging markets, which is highvolatility. That can come from three factors:natural disasters, external price shocks, and domestic policy instability.Traditional economies traditionally reliant on agriculture are especially vulnerable to disasters, such asearthquakes in Haiti, tsunamis in Thailand, or droughts in Sudan. But these disasters can lay the groundwork for additional commercial development, as it did in Thailand.
Emerging markets are more susceptible to volatile currency swings, such as those involving the U.S. dollar. They are also vulnerable to commodities swings, such as those of oil or food. That's because they don't have enough power to influence these movements. For example, when the United States subsidized corn ethanol production in 2008, it caused oil andfood pricesto skyrocket. That causedfood riotsin many emerging market countries.
When leaders of emerging markets undertake the changes needed for industrialization, many population sectors suffer, such as farmers who lose their land. Over time, this could lead to social unrest, rebellion, and regime change. Investors could lose all if industries become nationalized or the government defaults on its debt.
Growth Can Lead to High Returns
This growth requires a lot of investmentcapital. However, thecapital marketsare less maturein these countriesthan what is seen in developed markets. That's the fourth characteristic: currency swings.
Emerging markets don't have a solid track record offoreign direct investment. It's often difficult to get information on companies listed on theirstock markets. It may not be easy to sell debt, such ascorporate bonds, on the secondary market. All these components raise the risk. That also means there's a greater reward for investors willing to do the ground-level research.
If successful, rapid growth can also lead to the fifth characteristic, which is thehigher-than-average returnfor investors. That's because many of these countries focus on an export-driven strategy. They don't have the demand at home, so they produce lower-cost consumer goods and commodities for export to developed markets. The companies that fuel this growth will realize a profit. This interaction translates into higher stock prices for investors. It also means a higher return on bonds, which cost more to cover the additional risk of emerging market companies.
It is this quality that makes emerging markets attractive to investors. Not all emerging markets are good investments. They must have little debt, a growing labor market, and a government that isn't corrupt.
Note
The main emerging market powerhouses are China and India. Together, these two countries are home to more than 35% of the world's labor force and population. In 2021, their estimated combined gross domestic product (about $17.3 trillion) was greater than that of either the European Union ($15.2 trillion) and just behind that of the United States ($21 trillion).
What It Means to Individual Investors
There are many ways to take advantage of high growth rates and opportunities in emerging markets. The best is to pick an emerging market fund.
Many funds either follow or try to outperform the MSCI Index. That saves you time. You don't have to research foreign companies and economic policies. It also reduces risk by diversifying your investments into a basket of emerging markets, instead of just one.
Not All Emerging Markets Are Equal
Not all emerging markets are equally good investments. Since the2008 financial crisis, some countries took advantage of rising commodities prices to grow their economies. They didn't invest in infrastructure. Instead, they spent the extra revenue on subsidies and the creation of government jobs. As a result, their economies grew quickly, their people bought a lot of imported goods, and inflation soon became a problem. These countries included Brazil, Hungary, Malaysia, Russia, South Africa, Turkey,and Vietnam.
Since their residents didn't save, there wasn't a lot of local money for banks to lend to help businesses grow. The governments attractedforeign direct investmentby keeping the interest rates low. Although this helped increase inflation, it was worth it. In return, the countries received significant economic growth.
In 2013, commodity prices fell. These governments—reliant on the high price of a commodity—had either to cut back on subsidies or to increase their debt to foreigners. As thedebt-to-GDP ratio increased, foreign investments decreased.In 2014, currency traders also began selling their holdings. As currency values fell, it created a panic that led to mass sell-offs of currencies and investments.
However, other countries instead invested revenue in infrastructure and education for their workforce. China, Colombia, Czech Republic, Indonesia, Korea, Peru, Poland, Sri Lanka, and Taiwan all invested this way. In addition, because the people of these countries saved their money, there was plenty of local currency to fund new businesses. When the crisis occurred in 2014, these countries were ready.
