Chapter 37
Emerging Economies—New Paths

Emerging market investment involves several regions and types of investing. Even the concept has a variety of names including emerging markets, developing countries, or advancing economies and probably a few others. It is misleading to lump all the different emerging markets into a “category.” There are at least four major geographical regions that include Asia, Africa, Latin America, and Eastern Europe. You could then divide the countries by size of their economy. You might include Brazil, China, India, and Russia in one category and form others for the smaller economies. Some people increasingly have a separate category for “frontier” markets. You could also divide investments by government structures, such as dictatorships/authoritarian rule and democracies. As a final example, you could divide them by economic drivers such as: commodity, manufacturing, supply chain specialization, or services. All of this can help you define thematic investments.

Emerging economies may get a jump start on economic growth from a strong commodity base or cheap labor, but they usually need to expand from that base to experience broad-based sustainable growth. Generally, just ripping things out of the ground and selling them to more developed countries is not a good longterm economic plan for development. Success in these countries can come when capital gained from commodity or low-cost labor driven businesses can be redeployed into infrastructure that can help diversify economies. This can include government, legal, or physical infrastructure. Investments also need to be made in structures that help cultivate human capital, such as health care, communication, education, and housing.

Historically, physical transportation-focused infrastructure was always at the top of checklists when analyzing emerging market countries. However, economic drivers are more varied now. It is not that infrastructure does not matter, but in some cases communication infrastructure may be more critical. Infrastructure in general is important to attract capital and help growth, but it also must be scaled as the economy grows.

Technology can make infrastructure investment more efficient, which can help transform countries and regions more rapidly. For example, countries that did not have full coverage of wireline phone service for many years have been able to rapidly reach more people with service through the build out of wireless phone networks which can be more efficient in many regions. Once a mobile telecommunications service is set up, access to many other services can grow rapidly. In many regions in Africa the primary access to banking and financial transactions is through mobile phones. Additionally, in remote places access to services like medical consultations are available through mobile phones or other wireless devices.

There are many ways to invest in emerging markets, just as there is in all cross-border investing. One aspect of the investment that can play a bigger role in emerging markets is the currency in which you choose to make the investment. Typically, you can invest in instruments in the local currency or investments issued in one of the major currencies, usually U.S. dollars or Euros. One of the differences in emerging markets versus other cross-border investments is that it is usually more difficult, or costly, to hedge the local currency. Emerging market currencies also tend to be more volatile than the larger developed country currencies.

There is typically a full variety of investment vehicles available in emerging market countries; this includes government debt, quasi-government debt, equities, or the debt of companies that are in the emerging market. There are also forms of direct investing. The level of development of the local capital markets vary greatly and should be a consideration in how you choose to invest. There is also the potential to invest in major international companies that are based in developed countries that do a significant amount of business in emerging markets, which is a more indirect way of investing.

When you are making investments away from your home market there are always at least two layers of risk and opportunity. The first is the potential improvement or deterioration in the overall economic conditions of the country in which you are investing relative to your home country and opportunities in other markets. This can cause any form of emerging market investment to increase or decline in value. The overall perception of the quality of a country will typically shift much more in emerging markets than in developed countries. The other major opportunity, and risk, is through the vehicle in which you choose to invest, meaning the specific bond or stock or real estate that you purchase. There have been times when corporate bonds in a country trade better than the national government bonds. The entity in which you invest will impact your returns, but it will also be impacted by how the country is doing.

To undertake analysis at the country level there are many financial factors to consider and many areas of analysis that do not always lend themselves to quantitative measures, such as how good is the rule of law, government stability, and financial infrastructure. On the more quantitative side you can analyze trends in trade and capital flows. Government finances can be important, as can some measure of trends on general economic activity, strength of the government budget and debt levels at the national and local levels. You will also want to get an understanding of the country’s more critical industries. Analysis of a country’s financial system is also important. This should include an analysis of the major banks. Bank analysis should include capital ratios, mix of liabilities, and asset formation trends. Additionally, analysis of the financial system should include examining overall access to capital, as well as the flexibility and variety in financing sources. All these factors impact the ability to attract capital flows and make the capital stickier, which can be critical for emerging market nations.

Developing a framework for investing in emerging markets and all cross-border investing does require examination of some less quantitative factors and the use of checklists and matrices on these topics can often help categorize strengths and weaknesses and aid with the decision process. Some of the factors you would want to include on a matrix checklist at the country level might include:

The factors to consider in emerging markets investing are not that different from doing any other cross-border global investing. However, there is typically more volatility and greater variations by country than in the developed world. The impact of technology can be different on emerging market economies as the introduction of technology-driven competition may not face as many incumbent competitors, so changes can happen more rapidly and can have a larger impact on the overall economy. However, in some cases the existing industry leaders are even more powerful and entrenched than in the developed markets. Technological adoption may prove to be another key differentiator between emerging market nations.