Emerging markets or emerging market economies (EMEs) are in the process of achieving the building blocks of developed nations: they’re establishing regulatory bodies, creating infrastructure, fostering political stability, and supporting mature financial markets. But many emerging markets still face challenges that developed market countries have overcome — contributing to potential instability.
To further answer the question, “What are emerging markets?”, it helps to understand developed markets.
Developed economies have higher standards of living and per-capita income, strong infrastructure, stable political systems, and mature capital markets. The U.S., Europe, U.K, and Japan are among the biggest developed nations.
Because these economies wield so much power globally, many internationally focused investors don’t realize that in fact emerging markets make up the majority of the global economy.
India, China, and Russia are a few of the larger countries that fall into the emerging markets category. Some emerging market economies, like these three, are also key global players — and investors may benefit by understanding the opportunities emerging markets present.
What is an Emerging Market?
In essence, an emerging market refers to an economy that can become a developed, advanced economy soon. And because an emerging market may be a rapidly growing one, it may offer investment potential in certain sectors.
Investors tend to see these countries as potential sources of growth because their economies can resemble an established yet still-young startup company. The infrastructure and blueprint for success have been laid out, but things need to evolve before the economy can truly take off and ultimately mature. At the same time, owing to the challenges emerging market economies often face, there are also potential risks when investing in emerging markets.
Investors might bear the brunt of political turmoil, local infrastructure hurdles, a volatile home currency and illiquid capital markets (if certain enterprises are state-run or otherwise privately held, for example).
Emerging Market Examples
What constitutes an emerging market economy is somewhat fluid, and the list can vary depending on the source. Morgan Stanley Capital International (MSCI) classifies 27 countries as emerging; Dow Jones classifies 22 as emerging. There is some overlap between lists, and some countries may be added or removed as their status changes. Greece, for example, is no longer considered a developed market but an emerging one.
China and India are two of the world’s biggest emerging economies, and historically they were included in the BRIC grouping of developing nations, along with Brazil and Russia. Increasingly, though, investors see China and India as pushing the bounds of their emerging market status.
China is the second-largest economy globally by gross domestic product (GDP). It has a large manufacturing base, plenty of technological innovation, and the largest population of any country in the world.
Yet China still has a few characteristics typical of an emerging market. For example, the gross national income per capita falls below the threshold established by the World Bank for a developed country: about $10,000 per year versus the higher standard of about $12,000 per year. With its Communist-led political system, China has embraced many aspects of capitalism in its economy but investors may experience some turbulence related to government laws and policy changes. Last, the Renminbi, China’s official currency, has a history of volatility.
India is another big global economy, and it’s considered among the top 10 richest countries in the world, yet India still has a low per-capita income that is typical of an emerging market and poverty is widespread.
At the same time, India was ranked near China as being among the more advanced emerging markets, thanks to its robust financial system, growing foreign investment, and strong industrials, especially in telecommunication and technology.
Characteristics of an Emerging Market Economy
As noted above, there isn’t a single definition of an emerging market, but there are some markers that distinguish these economies from developed nations.
An emerging market economy is often in a state of rapid expansion. There is perhaps no better time to be invested in the growth of a country than when it enters this phase.
At this point, an emerging market has laid much of the groundwork necessary for becoming a developed nation. Capital markets and regulatory bodies have been established, personal incomes are rising, innovation is flourishing, and GDP is climbing.
Lower Per-Capita Income
The World Bank keeps a record of the gross national income (GNI) of many countries. For the fiscal year of 2021, lower-middle-income economies are defined as having GNI per capita of between $1,036 and $4,045 per year. At the same time, upper-middle-income economies are defined as having GNI per capita between $4,046 and $12,535. (By way of contrast, the U.S. is considered a high-income economy, with a GNI of $65,910)
The vast majority of countries that are considered emerging markets fall into the lower-middle and upper-middle-income ranges. For example, India, Pakistan, and the Philippines are lower-middle-income, while China, Brazil, and Mexico are upper-middle-income. Thus, all these countries are referred to as emerging markets despite the considerable differences in their economic progression.
Political and Economic Instability
For most EMEs, volatility is par for the course. Risk and volatility tend to go hand in hand, and both are common among emerging market investments.
Emerging economies can be rife with internal conflicts, political turmoil, and economic upheaval. Some of these countries might see revolutions, political coups, or become targets of sanctions by more powerful developed nations.
Any one of these factors can have an immediate impact on financial markets and the performance of various sectors. Investors need to know the lay of the land when considering which EMEs to invest in.
Infrastructure and Climate
While some EMEs have well-developed infrastructure, many are a mix of sophisticated cities and rural regions that lack technology, services and basic amenities like reliable transportation. This lack of infrastructure can leave emerging markets especially vulnerable to any kind of crisis, whether political or from a natural disaster.
For example, if a country relies on agricultural exports for a significant portion of its trade, a tsunami, hurricane, or earthquake could derail related commerce.
On the other hand, climate challenges may also present investment opportunities that are worth considering.
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The value of a country’s currency is an important factor to keep in mind when investing in emerging markets.
Sometimes it can look like stock prices are soaring, but that might not be the case if the currency is declining.
If a stock goes up by 50% in a month, but the national currency declines by 90% during the same period, investors could see a net loss, although they might not recognize it as such until converting gains to their own native currency.
Heavy Reliance on Exports
Emerging market economies tend to rely heavily on exports. That means their economies depend in large part on selling goods and services to other countries.
A developed nation might house all the needs of production within its own shores while also being home to a population with the income necessary to purchase those goods and services. Developing countries, however, must export the bulk of what they create.
Emerging Economies’ Impact on Local Politics vs. Global Economy
Emerging economies play a significant role in the growth of the global economy, accounting for about 50% of the world’s economic growth. Moreover, it’s predicted that by 2050 three countries will have the biggest economies: the U.S., China, and India, with only one currently being a developed economy.
But, while emerging markets help fuel global growth, some of those with higher growth opportunities also come with turbulent political situations.
As an investor, the political climate of emerging market investments can pose serious risks. Although there is potential for higher returns, especially in EMEs that are in a growth phase, investors need to consider the potential downside. For example, Thailand, Russia, and South Korea are emerging economies with high growth potential, but there is also a lot of political unrest in these regions.
Pros and Cons of Investing in Emerging Markets
Let’s recap some of the pros and cons associated with EME investments.
• High-profit potential: Selecting the right investments in EMEs at the right time can result in returns that might be greater than most other investments. Rapidly growing economies provide ample opportunity for profits. But as noted above, it’s impossible to guarantee the timing of any investment.
• Global diversification: Investing in EMEs provides a chance to hold assets that go beyond the borders of an investor’s home country. So even if an unforeseen event should happen that contributes to slower domestic growth, it’s possible that investments elsewhere could perform well and provide some balance.
• High volatility: As a general rule, investments with higher liquidity and market capitalization tend to be less volatile because it takes significant capital inflows or outflows to move their prices.
EMEs tend to have smaller capital markets combined with ongoing challenges, making them vulnerable to volatility.
• High risk: With high volatility and uncertainty comes higher risk. What’s more, that risk can’t always be quantified. A situation might be even more unpredictable than it seems if factors coincide (e.g. a drought plus political instability).
All investments carry risk, but EMEs bring with them a host of fresh variables that can twist and turn in unexpected ways.
• Low accessibility: While liquid capital markets are a characteristic of emerging markets, that liquidity still doesn’t match up to that of developed economies.
It may be necessary to consult with an investment advisor or pursue other means of deploying capital that may be undesirable to some investors.
Why Invest in Emerging Markets?
Emerging markets are generally thought of as high-risk, high-reward investments.
They are also yet another way to diversify an investment portfolio. Having all of your portfolio invested in the assets of a single country puts you at the mercy of that country’s circumstances. If something goes wrong, like social unrest, a currency crisis, or widespread natural disasters, that might impact your investments.
Being invested in multiple countries can help mitigate the risk of something unexpected happening to any single economy.
The returns from emerging markets might also exceed those found elsewhere. If investors can capitalize on the high rate of growth in an emerging market at the right time and avoid any of the potential mishaps, they stand to profit. Of course timing any market, let alone a more complex and potentially volatile emerging market, may not be a winning strategy.
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While developed nations like the U.S. and Europe and Japan regularly make headlines as global powerhouses, emerging market countries actually make up the majority of the world’s economy — and some very exciting opportunities for investors.
China and India are two of the biggest emerging markets, and not because of their vast populations. They both have maturing financial markets and strong industrial sectors and a great deal of foreign investment. And like other emerging markets, these countries have seen rapid growth in certain sectors (e.g. technology).
Despite their economic stature, though, both countries still face challenges common to many emerging economies, including political turbulence, currency fluctuations and low per-capita income.
It’s factors like these that can contribute to the risks of investing in emerging markets. And yet, emerging markets can also present unique investment opportunities owing to the fact that they are growing rapidly.
Emerging market exchange-traded funds (ETFs) might invest in different assets within a single country or spread their investments throughout multiple countries. Bonds can also play a role in an emerging market portfolio. Many countries with developing economies have used the issuance of new debt to borrow money to build out their infrastructure. That means some emerging economies could offer bonds with attractive yields.
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