Definition
An emerging market is a country that has some characteristics of a
developed market but is not a developed market. This includes countries that
may be developed markets in the future or were in the past. It may be a nation
with social or business activity in the process of rapid growth and industrialization.
The economies of China (excluding Hong Kong and Macau, as both are developed)
and India are considered to be the largest. According to The Economist,
many people find the term outdated, but no new term has gained much traction
yet. Emerging market hedge fund capital reached a record new level in the first
quarter of 2011 of $121 billion. The four largest emerging and developing
economies by either nominal or inflation-adjusted GDP are the BRIC countries (Brazil,
Russia, India and China). The next four largest markets are MIKT (Mexico, Indonesia,
South Korea and Turkey), although South Korea is not considered as an emerging
market by some sources. Iran is also considered as an emerging market.The ASEAN–China Free Trade Area, launched on January 1, 2010, is the largest regional emerging market in the world.
Emerging markets provide new investment opportunities, such
as elevated economic growth rates, higher expected returns and diversification
benefits. But there are risks - both to residents and foreign investors. One
example that has recently been making headlines is that of Turkey - a country
often hailed as a booming economy of almost miraculous proportions, and having
the honor of being one of the MINT
nations. But its on-again, off-again protests against Prime Minister Recep
Tayyip Erdogan have often resulted in violent clashes. Global speculation keeps
resurfacing that Turkey has its eyes on invading neighboring Syria. Allegedly in
a preemptive clampdown on chatter on the
issue, Turkey has shut down domestic access to popular social networks, banning
the video streaming site YouTube on March 27, following a similar ban of local Twitter
(Nasdaq:TWTR) feeds early in the month.
These are the kinds of signs of unrest that make potential foreign investors hesitant to set up business in an emerging economy. The foment in Turkey is still playing out and the end result is not yet predictable. But there are a number of risks that potential investors should be aware of before planting a flag in any number of emerging economies.
1) Foreign Exchange Rate Risk
Foreign investments in stocks and bonds will typically produce returns in the local currency of the investment. As a result, investors will have to convert this local currency back into their domestic currency. An American who purchases a Brazilian stock in Brazil will have to buy and sell the security using the Brazilian real. Therefore, currency fluctuations can impact the total return of investment. If, for example, the local value of a held stock increased by 5%, but the real depreciated by 10%, the investor will experience a net loss in terms of total returns when selling and converting back to U.S. dollars.
2) Less Liquidity
Emerging markets are generally less liquid than those found in the developed world. This market imperfection results in higher broker fees and an increased level of price uncertainty. Investors who try to sell stocks in an illiquid market face substantial risks that their orders will not be filled at the current price, and the transactions will only go through at an unfavorable level. Additionally, brokers will charge higher commissions, as they have to make more diligent efforts to find counterparties for trades. Illiquid markets prevent investors realizing the benefits of fast transactions.
3) Non-Normal Distribution
North American market returns arguably follow a pattern of normal distributions. As a result, financial models can be used to price derivatives and make somewhat accurate economic forecasts about the future of equity prices. Emerging market securities, on the other hand, cannot be evaluated using the same type of mean-variance analysis. Also, because emerging markets are undergoing constant changes, it is almost impossible to utilize historical information in order to draw proper correlations between events and returns.
4) Lax Insider Trading Restrictions
Although most countries claim to enforce strict laws against insider trading, none have proved to be as rigorous as America in terms of prosecuting unfair trading practices. Insider trading and various forms of market manipulation introduce market inefficiencies, whereby equity prices will significantly deviate from their intrinsic value. Such a system can be subject to extreme speculation, and can also be heavily controlled by those holding privileged information.
These are the kinds of signs of unrest that make potential foreign investors hesitant to set up business in an emerging economy. The foment in Turkey is still playing out and the end result is not yet predictable. But there are a number of risks that potential investors should be aware of before planting a flag in any number of emerging economies.
1) Foreign Exchange Rate Risk
Foreign investments in stocks and bonds will typically produce returns in the local currency of the investment. As a result, investors will have to convert this local currency back into their domestic currency. An American who purchases a Brazilian stock in Brazil will have to buy and sell the security using the Brazilian real. Therefore, currency fluctuations can impact the total return of investment. If, for example, the local value of a held stock increased by 5%, but the real depreciated by 10%, the investor will experience a net loss in terms of total returns when selling and converting back to U.S. dollars.
2) Less Liquidity
Emerging markets are generally less liquid than those found in the developed world. This market imperfection results in higher broker fees and an increased level of price uncertainty. Investors who try to sell stocks in an illiquid market face substantial risks that their orders will not be filled at the current price, and the transactions will only go through at an unfavorable level. Additionally, brokers will charge higher commissions, as they have to make more diligent efforts to find counterparties for trades. Illiquid markets prevent investors realizing the benefits of fast transactions.
3) Non-Normal Distribution
North American market returns arguably follow a pattern of normal distributions. As a result, financial models can be used to price derivatives and make somewhat accurate economic forecasts about the future of equity prices. Emerging market securities, on the other hand, cannot be evaluated using the same type of mean-variance analysis. Also, because emerging markets are undergoing constant changes, it is almost impossible to utilize historical information in order to draw proper correlations between events and returns.
4) Lax Insider Trading Restrictions
Although most countries claim to enforce strict laws against insider trading, none have proved to be as rigorous as America in terms of prosecuting unfair trading practices. Insider trading and various forms of market manipulation introduce market inefficiencies, whereby equity prices will significantly deviate from their intrinsic value. Such a system can be subject to extreme speculation, and can also be heavily controlled by those holding privileged information.
5)
Poor Corporate Governance System
A solid corporate governance structure within any organization is correlated with positive stock returns. Emerging markets sometimes have weaker corporate governance systems, whereby management, or even the government, has a greater voice in the firm than shareholders. Furthermore, when countries have restrictions on corporate takeovers, management does not have the same level of incentive to perform in order to maintain job security. While corporate governance in the emerging markets has a long road to go before being considered fully effective by North American standards, many countries are showing improvements in this area in order to gain access to cheaper international financing.
A solid corporate governance structure within any organization is correlated with positive stock returns. Emerging markets sometimes have weaker corporate governance systems, whereby management, or even the government, has a greater voice in the firm than shareholders. Furthermore, when countries have restrictions on corporate takeovers, management does not have the same level of incentive to perform in order to maintain job security. While corporate governance in the emerging markets has a long road to go before being considered fully effective by North American standards, many countries are showing improvements in this area in order to gain access to cheaper international financing.
