Emerging Market Economies Explained
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Emerging Market Economies Explained

Emerging market economies are developing nations with characteristics of both developing and developed markets. They experience rapid growth but come with higher investment risks.

Basics

An emerging market economy is defined as the economy of a developing nation that is progressively engaging with global markets as it evolves. These economies possess some, but not all, of the characteristics typically associated with developed markets.

Developed Markets Characteristics

Developed markets are characterized by robust economic growth, high per capita income, well-established equity and debt markets, accessibility to foreign investors, and a reliable regulatory system.

Progress in Emerging Markets

As emerging market economies develop, they become more integrated into the global economy. This integration leads to increased liquidity in local debt and equity markets, higher trade volume, foreign direct investment, and the establishment of modern financial and regulatory institutions. Notable emerging market economies include India, Mexico, Russia, Pakistan, Saudi Arabia, China, and Brazil. Critically, these economies transition from low-income, less-developed, often pre-industrial states to modern industrial economies with improved living standards.

Known Emerging Market Risks

Investors are attracted to emerging markets due to the potential for high returns, often accompanied by faster economic growth as measured by GDP. However, these markets also come with significantly greater risks.

These risks encompass political instability, domestic infrastructure issues, currency volatility, and illiquid equity markets, as many large companies may still be state-run or private. Additionally, local stock exchanges may not offer liquid markets for external investors.

Emerging markets generally lack highly developed market and regulatory institutions compared to advanced economies like the United States, Europe, and Japan. Market efficiency and strict standards in accounting and securities regulation are not on par with developed nations.

Signs of Progress

Emerging market economies typically possess a physical financial infrastructure, including banks, stock exchanges, and unified currencies. Over time, they adopt reforms and institutions similar to those in developed countries, promoting economic growth.

These countries shift from agricultural and resource extraction activities towards industrial and manufacturing pursuits. Governments typically implement deliberate industrial and trade strategies to encourage economic growth and industrialization. Export-led growth and import-substituting industrialization are common strategies.

Emerging market countries also invest in education systems, and physical infrastructure, and enact legal reforms to safeguard investors' property rights.

Frontier markets, on the other hand, are smaller than emerging markets, have lower per capita income, less market liquidity, and less industrialization. While they offer investment opportunities, they are considered riskier for investors.

Classification of Emerging Market Economies

Emerging market economies are classified in various ways by different observers. Income levels, financial system quality, and growth rates are popular criteria, but the list of emerging markets can vary depending on the source.

For example, the International Monetary Fund (IMF) classifies 20 countries as emerging markets, while Morgan Stanley Capital International (MSCI) counts 24. Standard and Poor's (S&P), FTSE Russell, and Dow Jones also differ in their classifications. Countries can be upgraded to developed status or downgraded to frontier markets based on institutional discretion.

Conclusion

Emerging market economies represent developing nations in transition toward developed status. They exhibit rapid GDP growth, increasing per capita income, improved liquidity in debt and equity markets, and established financial infrastructure. While they offer investment opportunities, it's crucial to be aware of the associated risks, including political instability, currency fluctuations, and lower liquidity, before considering investments in these markets.

International Monetary Fund (IMF)
MSCI Emerging Markets Index
Gross Domestic Product (GDP)
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