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What Are Emerging Markets?

How to Pick the Real Winners

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emerging markets

Carlos Helu, one of the richest men in the world, is from the emerging market of Mexico.

(Photo: Chris Hondros / Getty Images)
TPP-Countries

The TPP trade agreement will boost many emerging markets.

Photo: USTR
oil rig explosion

Brazil's oil fields boosted economic growth until 2013.

Chris Graythen/Getty Images

Definition: Emerging markets, also known as emerging economies or developing countries, are nations that are investing in more productive capacity. They are moving away from their traditional economies that have relied on agriculture and the export of raw materials. Leaders of developing countries want to create a better quality of life for their people. Therefore, they are rapidly industrializing, and adopting a free market or mixed economy.

Emerging markets are important because they drive growth in the global economy. Furthermore, their financial systems have become more sophisticated thanks to the 1997 currency crisis.

5 Characteristics of Emerging Markets

Emerging markets have five generally agreed upon characteristics. First, they have a lower-than-average per capita income. The World Bank defines developing countries as those with either low or lower middle per capita income, basically less than $4,034. (See World Bank list)

Low income is the first important criteria because this provides an incentive for the second characteristic, rapid growth. To remain in power, and to help their people, leaders of emerging markets are willing to undertake the rapid change to a more industrialized economy. In 2011, the economic growth of most developed countries, such as the U.S., Germany, the U.K. and Japan, was between 1-2%. In Turkey, Russia, Mexico and South Africa, it was between 3-4%, while Brazil's economy grew 4.5%. China and India both saw their economies grow more than a whopping 8%.

However, this rapid social and economic change can lead to the third characteristics, high volatility. This can come from three factors: natural disasters, external price shocks and domestic policy instability. Poor countries that are traditionally reliant on agriculture are especially vulnerable to disasters such as earthquakes (Haiti), tsunamis (Thailand) or droughts (Sudan). However, these disasters can actually lay the groundwork for additional commercial development, as it did in Thailand.

Emerging markets are more susceptible to currency swings, such as the dollar, and commodities, such as oil or food. That's because they don't have enough power to influence these movements. For example, when the U.S. subsidized corn ethanol production in 2008, it caused oil and food prices to skyrocket, leading to food riots in many emerging market countries.

When leaders of emerging markets undertake the changes needed for industrialization, many sectors of the population could suffer, such as farmers who lose their land. Over time, this could lead to social unrest, rebellion and regime change. Investors could lose all if industries become nationalized, or the government defaults on its debt.

If successful, the rapid growth can also lead to the fourth characteristics, higher-than-average return for investors. That's because many of these countries focus on an export-driven strategy. They don't have the demand at home, so they produce lower-cost consumer goods and commodities for developed markets. The companies that fuel this growth will profit more, which translates to higher stock prices for investors. It also means a higher return on bonds, which generally cost more to cover the additional risk of emerging market companies. (Source: IMF Working Paper, Ashoka Mody, What Is an Emerging Market?, September 2004)

It is this quality that makes emerging markets attractive to investors. Not all emerging markets are set up to become breakout nations, and therefore good investments. They must also have low debt, a growing labor market, and a government that isn't corrupt.

Global Emerging Markets

Most sources include the 21 countries in the MSCI Emerging Market Index in their list of emerging market countries (see below). Others that are sometimes considered emerging markets are: Argentina, Hong Kong, Jordan, Kuwait, Saudi Arabia, Singapore, UAE and Vietnam. (Source: Tarun Khanna, Harvard Business School, How Companies Break Into Emerging Markets)

However, the main emerging market powerhouses are China and India. Together, these two countries are home to 40% of the world's labor force and population. Together, their economic output ($15.9 trillion) is greater than that of either the EU ($15.6 trillion) or the U.S. ($15.3 trillion). Therefore, any discussion of emerging markets must keep in mind the powerful influence of these two super-giants. (Source: CIA World Factbook, 2011 statistics)

Investing in Emerging Markets

There many ways to take advantage of the high growth rate and opportunities in emerging markets. The best is to pick an emerging market fund. That saves you time, so you don't have to research foreign companies and economic policies. It reduces risk by diversifying your investments into a basket of emerging markets, instead of just one.

Many funds either follow or try to outperform the MSCI Emerging Market Index. This index tracks the market capitalization of every company listed on the countries' stock markets. In this way, it measures the combined stock performance of 21 emerging market countries: Brazil, Chile, China, Colombia, Czech Republic, Egypt, Hungary, India, Indonesia, Malaysia, Mexico, Morocco, Peru, Philippines, Poland, Russia, South Africa, South Korea, Taiwan, Thailand, and Turkey.

Breakout Nations

Not all emerging markets are equally good investments. Since the 2008 financial crisis, some countries took advantage of rising commodities prices to grow their economies. They didn't invest in infrastructure, but instead spent the extra revenue on subsidies and creating government jobs. As a result their economies grew quickly, their people bought a lot of imported goods, and inflation soon became a problem. These countries included Brazil, Hungary, Malaysia, Russia, South Africa, Turkey and Vietnam.

Since their residents didn't save, there wasn't a lot of local money for banks to lend to help businesses grow. Therefore, the governments attracted foreign direct investment by keeping interest rates low. Although this helped increase inflation, it was worth it in return for great economic growth.

However, in 2013 commodity prices fell. These governments either had to cut back on subsidies, or increase their debt to foreigners. As the debt-to-GDP ratio increased, foreign investments decreased. In 2014, currency traders also began selling their holdings. As currency values fell, it created a panic, leading to mass sell-offs of currencies and investments.

Breakout nations are those that invested revenue in infrastructure and education for their workforce. The people saved, so there was plenty of local currency to fund new businesses. When the crisis occurred in 2014, they were ready. These countries are: China, Czech Republic, Indonesia, Korea, Poland, Sri Lanka and Taiwan. Article updated January 25, 2014

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