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. They are rapidly industrializing and adopting a free market or mixed economy.
Five Defining Characteristics
1. Lower-Than-Average Per Capita Income
Emerging markets have lower-than-average per capita income. Low income is the first important criterion because this provides an incentive for the second characteristic, which is rapid 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.
The World Bank defines developing countries as those with per capita income of $3,995 or less.
2. Brisk Economic Growth
In 2019, the economic growth of most developed countries, such as the United States, Germany, Mexico, and Japan, was less than 3%. Growth in Egypt, Poland, India, and Malaysia, was 4% or more. China and Vietnam saw their economies grow by around 6% to 7%.
3. High Volatility
Rapid social change leads to the third characteristic, which is high volatility. 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 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.
4. Currency Swings
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 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 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.
5. Potential For Growth
This growth requires a lot of investment capital. However, the capital markets are less mature in these countries than what is seen in developed markets. That's the fourth characteristic. They 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 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 the 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 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 costs 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.
Emerging Markets List
The Morgan Stanley Capital International Emerging Market Index (MSCI Index) lists 26 countries. They are Argentina, Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Pakistan, Peru, Philippines, Poland, Qatar, Russia, Saudi Arabia, South Africa, Taiwan, Thailand, Turkey, and United Arab Emirates.
Other sources also list another eight countries as falling into the emerging market category. They include Argentina, Hong Kong, Jordan, Kuwait, Saudi Arabia, Singapore, and Vietnam.
The main emerging market powerhouses are China and India. Together, these two countries are home to over 35% of the world's labor force and population. In 2018, their combined gross domestic product (about US$28.1 trillion) was greater than that of either the European Union ($18.8 trillion) or the United States ($20.5 trillion). In any discussion of emerging markets, the powerful influence of these two super-giants must be kept in mind.
Investing in Emerging Markets
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 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. 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 attracted foreign direct investment by 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 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 that led to mass sell-offs of currencies and investments.
Others invested revenue in infrastructure and education for their workforce. Because their people saved, 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, and Taiwan.
The Bottom Line
Emerging market economies are countries in the process of becoming industrialized economies. They have these following characteristics:
- Low-to-mid per capita income.
- The brisk pace of economic growth.
- Commodity and currency swings.
- High market volatility—possibly caused by natural disasters, external price shocks, or domestic policy instability.
- Huge growth potential.
Emerging markets offer large opportunities for foreign investment. Ideally, those that invite sound investment must have a stable government with low corruption incidences, low debt-to-GDP ratio, and a good pool of labor. Many of these developing markets though pose less than ideal conditions. They may expose investors to great risk from:
- Weak market capacity: constrained financial system.
- Political instability.
- Low corporate governance or transparency.
- Limited legal protection for investors.
- High costs of doing business—implicit and explicit costs such as commissions, fees, taxes, degree of market liquidity, etc.
- Restrictions on foreign accessibility.
- Volatility: high market and currency fluctuations.