What Are Emerging Markets? 5 Defining Characteristics

How to Pick the Real Winners

China Stock Market
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Definition: Emerging markets, also known as emerging economies or developing countries, are nations that are investing in more productive capacity. They are moving away from their traditional economies that have relied on agriculture and the export of raw materials. Leaders of developing countries want to create a better quality of life for their people. Therefore, they are rapidly industrializing and adopting a free market or mixed economy.

Emerging markets are important because they drive growth in the global economy. Furthermore, their financial systems have become more sophisticated thanks to the 1997 currency crisis.

5 Characteristics of Emerging Markets

Emerging markets have five agreed upon characteristics. First, they have a lower-than-average per capita income. The World Bank defines developing countries as those with either low or lower middle per capita income of less than $4,035. (See World Bank list)

Low income is the first important criteria because this provides an incentive for the second characteristic, rapid growth. To remain in power, and to help their people, leaders of emerging markets are willing to undertake the rapid change to a more industrialized economy. In 2015, the economic growth of most developed countries, such as the United States, Germany, the United Kingdom and Japan, was between less than 3 percent.

Growth in Egypt, Turkey, and the United Arab Emirates was 4 percent or more. China and India both saw their economies grow around 7 percent.

Rapid social change leads to the third characteristics, high volatility. That can come from three factors: natural disasters, external price shocks, and domestic policy instability.

Traditional economies that are traditionally reliant on agriculture are especially vulnerable to disasters such as earthquakes 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 the dollar, and commodities, such as oil or food. That's because they don't have enough power to influence these movements. For example, when the U.S. subsidized corn ethanol production in 2008, it caused oil and food prices to skyrocket. That caused food riots in many emerging market countries.

When leaders of emerging markets undertake the changes needed for industrialization, many sectors of the population 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.

This growth requires a lot of investment capital. But the capital markets are less mature in these countries than the developed markets. That's the fourth characteristic. They simply don't have a solid track record of foreign direct investment.

It's often difficult to get information on companies listed on their stock markets. It may not be easy to sell debt, such as corporate bonds, on the secondary market. All these components raise the risk. That also means there's greater reward for investors willing to do the ground-level research. (Source: "The Difference Between Developed, Emerging and Frontier Markets, NASDAQ, May 11, 2012.)

If successful, the rapid growth can also lead to the fifth characteristics, higher-than-average return for 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 developed markets. The companies that fuel this growth will profit more, which 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. (Source: Ashoka Mody, "What Is an Emerging Market?" IMF Working Paper,  September 2004,)

It is this quality that makes emerging markets attractive to investors. Not all emerging markets are set up to become breakout nations, and, therefore, good investments. They must also have little debt, a growing labor market, and a government that isn't corrupt.

Emerging Markets List

The MSCI Emerging Market Index lists 23 countries. They are Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Qatar, Peru, Philippines, Poland, Russia, South Africa, South Korea, Taiwan, Thailand, Turkey, and United Arab Emirates. This index tracks the market capitalization of every company listed on the countries' stock markets.

Other sources also list another eight countries. They are Argentina, Hong Kong, Jordan, Kuwait, Saudi Arabia, Singapore, and Vietnam. (Source: Tarun Khanna, "How Companies Break Into Emerging Markets," Harvard Business School, )

The main emerging market powerhouses are China and India. Together, these two countries are home to 40 percent of the world's labor force and population. Their combined economic output ($27.8 trillion) is greater than that of either the European Union ($19.18 trillion) or the United States ($18.0 trillion). Therefore, any discussion of emerging markets must keep in mind the powerful influence of these two super-giants. (Source: CIA World Factbook, 2015 statistics.)

Investing in Emerging Markets

There many ways to take advantage of the high growth rate 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, so you don't have to research foreign companies and economic policies. It reduces risk by diversifying your investments into a basket of emerging markets, instead of just one.

Not all emerging markets are equally good investments. Since the 2008 financial crisis, some countries took advantage of rising commodities prices to grow their economies. They didn't invest in infrastructure, but instead spent the extra revenue on subsidies and creating 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. Therefore, the governments attracted foreign direct investment by keeping interest rates low. Although this helped increase inflation, it was worth it in return for significant economic growth.

In 2013 commodity prices fell. These governments either had to cut back on subsidies, or increase their debt to foreigners. As the debt-to-GDP ratio increased, foreign investments decreased. In 2014, currency traders also began selling their holdings. As currency values fell, it created a panic, leading to mass sell-offs of currencies and investments.

Others invested revenue in infrastructure and education for their workforce. The people saved, so there was plenty of local currency to fund new businesses. When the crisis occurred in 2014, they were ready. These countries are China, Colombia, Czech Republic, Indonesia, Korea, Peru, Poland, Sri Lanka, South Korea, and Taiwan. For more, see Breakout Nations.