What Are Emerging Markets?
Emerging markets refer to economies of developing nations that are transitioning toward becoming more advanced, integrated, and industrialized. These countries typically exhibit characteristics of both developing and developed markets, representing a significant segment of global finance and offering unique opportunities within international investing. A key aspect of an emerging market is its ongoing process of industrialization, often accompanied by strong economic growth, an expanding middle class, and increasing integration with the global economy. Investors often consider emerging markets for their potential for higher risk-adjusted returns, though they inherently carry greater risks than more mature economies. Diversifying a portfolio management strategy to include emerging markets can impact overall diversification benefits.
History and Origin
The term "emerging markets" was coined in 1981 by Antoine Van Agtmael, an economist at the International Finance Corporation (IFC), a division of the World Bank. The IFC introduced the concept to highlight a new asset class and attract foreign investment into promising stock markets in developing countries. Before this, these economies were often simply referred to as "less developed countries" (LDCs). The new terminology sought to convey a sense of dynamism and opportunity, emphasizing their potential for growth and integration into global capital markets. The World Bank notes that while it no longer maintains a definitive list of "emerging markets," the database developed by the IFC for this purpose was eventually acquired by Standard & Poor's.5
Key Takeaways
- Emerging markets are developing economies characterized by rapid industrialization, increasing integration into global markets, and often high economic growth.
- They typically have a unified currency, stock market, and banking system, and are in the process of adopting reforms seen in developed economies.
- While offering the potential for higher returns due to their growth trajectories, investments in emerging markets come with elevated risks, including currency volatility and geopolitical risk.
- Major institutions like the International Monetary Fund (IMF) and MSCI classify economies, though their specific lists of emerging markets can vary.
- These markets play an increasingly significant role in the global economy, contributing a growing share of global Gross Domestic Product (GDP).
Interpreting Emerging Markets
Interpreting emerging markets involves assessing a complex interplay of economic, political, and social factors. Investors evaluate these markets based on various indicators such as their Gross Domestic Product (GDP) growth rates, levels of industrialization, per capita income, and the maturity of their financial systems. A key aspect is the degree of market accessibility for foreign investors and the overall liquidity of their equity and debt markets. High growth potential is often a primary attraction, but this must be balanced against inherent risks such as political instability, regulatory changes, and exposure to global economic shocks. Understanding the specific nuances of a country's legal and industrial framework is essential before committing capital.4
Hypothetical Example
Consider an investor, Sarah, who is constructing an asset allocation strategy for her long-term retirement portfolio. She has a significant portion invested in developed markets, but seeks higher potential returns and greater diversification. After researching, she decides to allocate 15% of her portfolio to an emerging market exchange-traded fund (ETF). This ETF holds a basket of stocks from countries like India, Brazil, and Vietnam. Sarah understands that while these markets offer robust growth prospects due to their burgeoning middle classes and industrial expansion, they also expose her to greater currency volatility and potential regulatory shifts, which could impact the fund's overall valuation. Despite these risks, the potential for strong performance during global economic expansion makes emerging markets an attractive component of her overall strategy.
Practical Applications
Emerging markets feature prominently in various aspects of global investing and economic analysis. For investors, they serve as a source of diversification and potentially higher returns, particularly through investments in equity and debt. Many large financial institutions and fund managers offer dedicated emerging market funds as part of their investment product suites, enabling easier access for individual and institutional investors. According to Societe Generale, investments in emerging markets typically have limited correlation with traditional assets, making them valuable for portfolio diversification.3
Additionally, emerging markets are crucial for global trade and foreign direct investment (FDI). Multinational corporations often establish operations in these regions to tap into growing consumer bases and leverage lower production costs. Central banks and international organizations, such as the International Monetary Fund (IMF), closely monitor the economic health of emerging markets, as their performance significantly impacts global economic stability and growth projections. Policymakers in these countries also focus on attracting capital inflows and implementing reforms that strengthen their capital markets and regulatory environments to foster sustainable development.
Limitations and Criticisms
Despite their appeal, emerging markets come with notable limitations and criticisms. A primary concern is their inherent volatility and elevated risk profiles compared to developed markets. Factors such as political instability, rapid changes in regulations, and macroeconomic imbalances can lead to significant market swings. For instance, a working paper from the National Bureau of Economic Research (NBER) highlights that emerging markets often exhibit higher and more volatile stock market returns compared to richer countries, and their returns are more sensitive to global predictable growth shifts.2 This heightened sensitivity makes them more susceptible to global "risk-off" events, where investors withdraw capital from perceived riskier assets.
Furthermore, issues such as lower corporate governance standards, less transparent financial reporting, and the potential for greater inflation can pose challenges for investors. Restrictions on foreign exchange transactions and even the risk of expropriation are also cited as potential drawbacks.1 While promising high economic growth, the trajectory of emerging markets is not guaranteed to be linear; external shocks, internal policy missteps, or a slowdown in global trade can significantly impact their performance and ability to "emerge" to developed status.
Emerging Markets vs. Frontier Markets
While often discussed in the same breath, emerging markets and frontier markets represent distinct stages of economic development and market maturity.
| Feature | Emerging Markets | Frontier Markets |
|---|---|---|
| Development Stage | Transitioning from developing to developed. | Less developed, often in early stages of market infrastructure. |
| Market Size/Liquidity | Larger, more developed, and generally more liquidity in their capital markets. | Smaller, less liquid, and often less accessible to foreign investors. |
| Risk Profile | Higher risk than developed markets, but lower than frontier markets. | Highest risk profile, due to less stable political and economic environments. |
| Regulation | Improving regulatory frameworks and governance. | Less mature regulatory environments, higher potential for unforeseen changes. |
| Examples | China, India, Brazil, Mexico, South Africa. | Vietnam, Kenya, Argentina, Pakistan, Sri Lanka (classifications can vary by index provider). |
The key distinction lies in their relative maturity and accessibility. Emerging markets have established financial systems, more robust legal frameworks, and a greater degree of integration with the global economy. Frontier markets, on the other hand, are the next stage down the development ladder, offering potentially even higher growth rates but with significantly greater risks and lower liquidity.
FAQs
What determines if a country is an emerging market?
There isn't a single, universally agreed-upon definition, but classification generally depends on factors like per capita income, the rate of economic growth, the size and liquidity of its stock and bond markets, and the openness and stability of its financial system. Major index providers like MSCI and FTSE Russell, and institutions like the International Monetary Fund (IMF), publish their own lists based on varying criteria.
Are investments in emerging markets riskier than developed markets?
Yes, investments in emerging markets are generally considered riskier than those in developed markets. This is due to factors such as higher currency volatility, political instability, less developed regulatory systems, and greater susceptibility to global economic shocks. However, this higher risk often comes with the potential for higher returns.
What are the benefits of investing in emerging markets?
The primary benefits include the potential for higher returns driven by strong economic growth and industrialization, and improved diversification for a portfolio due to their typically lower correlation with developed markets. They can also offer exposure to growing consumer bases and innovative new companies.
Can emerging markets become developed markets?
Yes, countries can "graduate" from emerging market status to developed market status as their economies mature, per capita income rises, financial markets deepen, and regulatory frameworks strengthen. Examples include South Korea and Taiwan, which are now widely considered developed markets by many classification bodies.
What role do global events play in emerging markets?
Global events, such as changes in global interest rates, shifts in trade policy, or geopolitical tensions, can have a significant impact on emerging markets. These economies are often more sensitive to external capital flows, commodity price fluctuations, and global risk sentiment, making them more vulnerable to "push" factors from advanced economies.