An emerging market economy is the economy of a developing nation that is becoming more engaged with global markets as it grows, and which displays some, but not all, of the characteristics of a developed market. Emerging market debt offers the investor high expected returns, which could be increasingly attractive in today’s yield starved world, however this comes at the expense of higher risk. Many emerging countries are highly dependent on foreign borrowing, which can later create crises in their economy, currency, and financial markets should conditions deteriorate significantly.
Many emerging countries also have unstable political and social systems. Their undiversified nature makes them susceptible to volatile capital flows and economic crises. Thus, investing in emerging markets brings a host of additional risks that a potential investor must carefully take into account. From a credit perspective, the main risk is credit risk or simply—does the country have the ability and willingness to pay back its debt? Economic, political, and legal risks are also important.
Some signs that an emerging market is more susceptible to risk include a large amount of wealth concentration and the absence of a middle class. Often this would involve economies that display a greater dominance of cyclical industries, including commodities. The characteristics of the population itself is a fundamental factor. This includes the level of education of the workforce, the supporting infrastructure as well as the level of technological advancement.
Furthermore, economies that impose restrictions on capital flows and trade, as well as currency restrictions, are considered higher risk. This is often accompanied by inadequate fiscal and monetary policies. Large amounts of foreign borrowing in foreign currencies is considered a red flag.
In order to gauge fiscal policy, most analysts examine the deficit-to-GDP ratio. As a rule of thumb, ratios greater than 4 percent indicate substantial credit risk. Most emerging countries borrow short term and must refinance on a periodic basis. A build-up of debt increases the likelihood that the country will not be able to make its payments. A second important measure of fiscal health is the debt-to-GDP ratio. Ratios of 70 percent to 80 percent or higher has proven troublesome for emerging countries in the past.
To compensate for the higher risk in these countries, investors should expect a real (before inflation) GDP growth rate of at least 4 percent, as this facilitates the servicing of the growth in debt. Although emerging countries are dependent on foreign financing for growth, too much debt can eventually lead to a financial crisis if foreign capital flees the country. These financial crises are accompanied by currency devaluations and declines in emerging market asset values. Foreign debt levels greater than 50 percent of GDP indicate that the country may be overleveraged.
The level of foreign exchange reserves relative to short-term debt is important because many emerging country loans must be paid back in a foreign currency. Foreign exchange reserves less than 100 percent of short-term debt is a sign of trouble (greater than 200 percent is considered strong).
The government’s stance regarding structural reforms and property rights is important. If the government is supportive of structural reforms necessary for growth, then the investment environment is more hospitable. When the government is committed to responsible fiscal policies, competition, and the privatization of state-owned businesses, there are better prospects for growth. Weak enforcement laws, property rights laws, nationalization of property, and corruption are hazard signs. Coalition governments are also seen as riskier because of the inherent political, and therefore policy, instability.
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