Emerging Markets: Analysing investment opportunities in emerging economies and evaluating the risks associated with these markets

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Emerging Markets: Analysing investment opportunities in emerging economies and evaluating the risks associated with these markets

Authored by Mohit Ralhan, Chief Executive Officer, TIW Capital.

Emerging markets is a term generally used for low to middle-income countries with relatively faster-growing economies. The term was first used by Antoine van Agtmael in 1981 when he was associated with International Finance Corporation (IFC) as an economist. The first ten countries tracked by the IFC under the umbrella of emerging markets were Argentina, Brazil, Chile, Greece, India, Jordan, South Korea, Mexico, Thailand and Zimbabwe. IFC went ahead and created the Emerging Market Database and Antoine pitched the idea of investing in the stock markets of the emerging world, which started the series of launching multiple emerging market-oriented funds by several investment houses. South Korea proved to be the earliest primary beneficiary of this trend, becoming a high-income country in just a few generations. But several countries of the original ten also failed spectacularly in generating returns for investors. Also over the years, many more countries have been included in the ever-expanding list of emerging markets making the term very loosely define in today’s world. 

Essentially, the whole investment paradigm of finding emerging markets and investing in them boils down to the search for sustainably high economic growth. Over the last 30 years, the average economic growth in the USA and Western Europe has been under 3 per cent while economic growth in Japan has been under 1 per cent. As the economic growth in these developed economies, continued to slow down significantly, the investors started to look beyond in search of higher growth. This search took them to different destinations during different periods from fast-growing economies in Asia to Eastern Europe and Latin America.  

A subset of emerging economies constituting the top 5 leading ones was brought under one umbrella term called BRIC by Goldman Sach’s economist Jim O’Neill in 2001, constituting Brazil, Russia, India and China. The block of these four countries looked extremely logical for investors given their relatively larger geographies, populations, economic growth and overall, long-term growth potential. This block offered more sustainable exposure to emerging markets till the faltering of Russia with the start of the Russia-Ukraine war. But overall, China and India have been the flag bearer of emerging markets for over two decades now and even today no other country appears to have as much potential.  

The primary reason for several countries to disappear after showing short-term potential is rooted in the political risk and weakness of local institutions. While the investors are still searching for long-term growth potential, they must evaluate a few other critical factors as well. Political stability is the key. The recent scare in Brazil where there was doubt about the possibility of a peaceful transfer of power proves a case in point.

It increases the volatility of investments which is universally disliked by long-term investors. The strength of financial institutions and regulatory control is also very critical followed by lesser and declining government control on businesses i.e., increasing privatization. The evaluation often transcends subjectivity and an in-depth understanding of the on-ground business practices rather than looking at high-level economic data. For example, Argentina was one the leading emerging market in the 1990s with a solid march towards privatization, with all high, but it went into a deep crisis at the turn of this century. This highlights the risks of investing in emerging markets wherein countries that lack strong institutions and a path of making institutions even stronger, can quickly descend into chaos and crisis.  

Nevertheless, the quest for growth continues. In a world starved of good growth opportunities, Investors are overallocated to slower-growing assets of developed markets. While about 28 per cent of the world’s GDP is contributed by countries that are defined as emerging markets by the World Bank, only 10 per cent of equity markets are contributed by emerging markets and the portfolio allocation to emerging market equities is a meagre 3 per cent. There is a strong case for correcting the portfolio allocation and there is still a market demand of skill full fund managers and investment professionals who can navigate the labyrinths of investing in emerging markets. 

A good start will be to look at faster-growing economies and then eliminate those which lack political stability, strong financial and regulatory institutions, ease of capital convertibility and relatively stable currency. Apart from China and India, other countries that can potentially make the cut includes Brazil, Indonesia and countries in the Middle East. Given the risks, it’s better advised to take a broad portfolio approach and steer clear of the sectors, where local government doubles up as business owners.  

By all yardsticks, India remains a very attractive destination for increasing portfolio exposure to emerging markets. It has an extremely stable political environment, strong forex reserves and increasingly progressive institutions. Its democratic, financial and regulatory institutions have performed exceedingly well over the last twenty years, shielding its economy reasonably well from both subprime and COVID-19 crisis. 

It has demonstrated huge potential to build world-class global companies in several sectors including technology, pharmaceuticals, chemicals and automotive sectors. Its start-up ecosystem is now the third largest in the world feeding into its fast-growing economy. As the anomaly of global portfolio allocation to emerging markets corrects, India is likely to be the largest beneficiary.  

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