Emerging Markets

Emerging markets are economies that are industrializing and opening up to global trade and finance, with incomes and institutions between those of developing countries and developed countries. Commonly cited examples include China, India, Brazil, Mexico, Indonesia, Turkey, South Africa, Saudi Arabia and Poland. The term is used both by economists, to describe a stage of development, and by investors, to describe a class of stock and bond markets.

The phrase was coined in 1981 by Antoine van Agtmael, then at the World Bank's International Finance Corporation, as a more appealing name than "Third World" for a fund investing in such countries. It overlaps with, but is not the same as, the BRICS grouping, which began as an investment acronym from Goldman Sachs economist Jim O'Neill in 2001. Smaller, less accessible markets such as Vietnam, Kenya or Bangladesh are often called frontier markets.

Think of a neighbourhood that is going up in the world. New shops are opening, families are moving into better homes, and land prices are rising. There is money to be made, but the streets are still rough in places, the rules are not always enforced, and a bad year can hit hard.

Investors treat emerging markets the same way. They expect faster growth and higher returns than in rich countries, but also bigger swings. When money is cheap in the United States, investors pour into these markets looking for better returns; when US rates rise or fear spreads, they often pull out all at once.

• Index providers. MSCI, FTSE Russell and S&P Dow Jones classify markets using income plus market size, liquidity, openness to foreign investors and ease of moving money in and out. The MSCI Emerging Markets Index, launched in 1988, is the most widely tracked equity stock market index for the group; its largest weights are in China, Taiwan and India. Reclassification decisions can move large amounts of passive money.
• Bond indices. J.P. Morgan's EMBI family tracks dollar-denominated government bonds (often issued as Eurobonds), while its GBI-EM indices track local-currency government debt.
• IMF. The International Monetary Fund (IMF) groups "emerging market and developing economies" together and separately identifies emerging market and middle-income economies based on size, market access and income.

Emerging markets depend heavily on foreign capital, and that capital is volatile. Portfolio inflows, sometimes called hot money, rise when global interest rates are low and investors chase yield through strategies such as the carry trade. When the Federal Reserve tightens or the dollar strengthens, flows can reverse in a "sudden stop", pushing down currencies and raising borrowing costs.

Many past crises followed this pattern: Mexico in 1994, East Asia in 1997, Russia in 1998, Argentina in 2001 and the 2013 "taper tantrum", when signals that the Fed would slow bond buying hit countries with large current account deficits, labelled the "Fragile Five" by Morgan Stanley (Brazil, India, Indonesia, South Africa and Turkey). A key weakness was "original sin", the inability to borrow abroad in one's own currency, which creates a currency mismatch: when the exchange rate falls, dollar debts balloon in local terms and can trigger a currency crisis and capital flight.

Since the 2000s many emerging economies have built large foreign exchange reserves, adopted inflation targeting with more flexible currencies, and developed local-currency bond markets. In 2012 the IMF accepted that temporary capital controls can be appropriate in some circumstances.

For a foreign investor, the return on an emerging-market asset depends on both the local return and the currency move. A simple approximation is:

• $R_{\text{USD}}$ is the return measured in US dollars.
• $R_{\text{local}}$ is the return in the local currency, such as a bond's interest plus price change.
• $\Delta e$ is the percentage change in the local currency against the dollar (negative if it depreciates).

Example: a local government bond returns 12% in a year, but the currency falls 8% against the dollar. The dollar return is roughly $12\% - 8\% = 4\%$, only slightly above a US Treasury paying, say, 4%. The extra yield is compensation, or a risk premium, for this currency risk plus sovereign risk, political risk, weaker governance and lower liquidity. Investors also use the gap between dollar emerging-market bond yields and US Treasury securities, the "spread", as a gauge of perceived default risk.

Supporters of the asset class point to faster growth, young populations and diversification benefits. Critics note that stock returns have often lagged GDP growth, because new share issuance dilutes investors and state influence can override minority shareholders, and that correlations with developed markets rise in crises, just when diversification is needed most.

• A shrinking label. Economies as different as Taiwan, with high income, and Egypt are grouped together, and some analysts argue that China, now the second-largest economy, should be treated as a category of its own.
• Graduation. Few emerging markets have become developed in recent decades, raising concern about the middle-income trap.
• Dependence on US policy. Emerging-market policymakers argue that US monetary decisions export volatility to them; others reply that strong domestic policy frameworks have made most emerging markets far more resilient than in the 1990s.

• MSCI Market Classification
• IMF World Economic Outlook