Emerging Markets--Miracle or Mirage?

Regular investors could not have gone through the past few years without noticing the buzz on emerging markets. According to the Financial Times, "five years ago, it was 'why bother?' Now the question global investors are asking is: can we afford to ignore emerging markets?"

A term coined in the early 1980s by the World Bank's International Finance Corporation, "emerging markets" (EMEs) refer to "an economy with low-to-middle per capita income." About 80% of the world's population live in emerging market economies. That, however, is not to say that emerging markets are necessarily small and poor. For example, China and India are considered emerging markets, so are Brazil, Argentina, Mexico, Russia, Iran, Iraq, Egypt and South Africa.

The 1990s saw confidence plummet in emerging market investments, due to the three major regional economic crises--Mexico and Argentina in 1994, Asia in 1997, and Russia in 1998. Because of the transitioning nature of these economies, investments are high-risked and volatile.

Now, the good news is, the early years of this decade have seen significant and solid economic performance from many of the EMEs. The Financial Times reported that Brazil and Venezuela announced they were buying back billions of dollars worth of their Brady bonds. These securities, named after Nicholas Brady, a former US Treasury secretary, still carry a stigma because of their association with past financial crises. Gone are the days when loans to the EMEs have to be forgiven, restructured or reformed after years of default.

Yet should we, as private investors and prudent watchers of the global economy, see this as a mere mirage, like the short-lived boom in the early 1990s, or a miracle that will continue to develop? The Financial Times expressed confidence that good performance in the past few years will probably continue. "In 2003-05 emerging market shares more than doubled, with total returns of 165 per cent. East European markets returned 226 per cent, Latin American markets 265 per cent and Asian markets (outside Japan) 122 per cent."

What generates this optimism is the fact that, ever since the regional crises in the 1990s, there had been some real structural changes in these economies, including reduction of current account deficits, real GDP growth, reduction of foreign debt, and a controlled inflation rate. The important perspective, though, is that the risk involved in investing in EMEs may still, afterall, be higher than in developed economies. While no economy is immune to cyclical performance, EMEs are still more vulnerable to large scale crises than developed economies. In many of the EMEs, social and political stability are still not guaranteed--and that is just one possible external risk to name. Cautious optimism is probably the best attitude toward EME investments now.

Sources:
Christopher Brown-Humes, A grown-up Brady bunch? Why returns in emerging markets are vigorous, Financial Times, Mar. 2, 2006.

Emerging Market Directory, What is an Emerging Market?

Reem Hekal, What is Emerging Market Economy? Investopia


Robert Lenzner, Book Review: Robert Rubin on Surviving the 1990s