What Are Emerging Markets? Five Defining Characteristics

How to Pick the Real Winners

Woman in front of Chinese stock market
••• Investors observe stock market at a stock exchange corporation on April 7, 2015 in Huaibei, Anhui province of China. Photo: Getty Images AsiaPac

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. They are rapidly industrializing and adopting a free market or mixed economy.

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

Five Characteristics of Emerging Markets

Emerging markets have five characteristics. First, they have a lower-than-average per capita income. The developing countries as those with either low or lower middle per capita income of less than $4,035.

Low income is the first important criteria because this provides an incentive for the second characteristic which is 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 2015, the economic growth of most developed countries, such as the United States, Germany, the United Kingdom and Japan, was between less than 3 percent. Growth in Egypt, Turkey, and the United Arab Emirates was 4 percent or more.

China and India both saw their economies grow around 7 percent.

Rapid social change leads to the third characteristic which is high volatility. That can come from three factors: natural disasters, external price shocks and domestic policy instability. Traditional economies that are traditionally reliant on agriculture are especially vulnerable to disasters, such as earthquakes in Haiti, tsunamis in Thailand, or droughts in Sudan. But these disasters can lay the groundwork for additional commercial development as it did in Thailand.

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

When leaders of emerging markets undertake the changes needed for industrialization, many sectors of the population 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.

This growth requires a lot of investment capital. But the capital markets are less mature in these countries than the developed markets. That's the . They simply don't have a solid track record of foreign direct investment. It's often difficult to get information on companies listed on their stock markets. It may not be easy to sell debt, such as corporate bonds, on the secondary market. All these components raise the risk. That also means there's greater reward for investors willing to do the ground-level research.

If successful, the rapid growth can also lead to the fifth characteristic which is the 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. This translates into higher stock prices for investors. It also means a higher return on bonds which costs more to cover the additional risk of companies.

It is this quality that makes emerging markets attractive to investors. Not all emerging markets are good investments. They must have little debt, a growing labor market, and a government that isn't corrupt.

Emerging Markets List

The Morgan Stanley Capital International Emerging Market Index lists 23 countries. They are Brazil, Chile, China, Colombia, Czech Republic, Egypt, Greece, Hungary, India, Indonesia, Korea, Malaysia, Mexico, Morocco, Qatar, Peru, Philippines, Poland, Russia, South Africa, South Korea, Taiwan, Thailand, Turkey and United Arab Emirates. This index tracks the market capitalization of every company listed on the countries' stock markets.

also list another eight countries. They are Argentina, Hong Kong, Jordan, Kuwait, Saudi Arabia, Singapore, and Vietnam.

The are China and India. Together, these two countries are home to 40 percent of the world's labor force and population. Their combined economic output ($27.8 trillion) is greater than that of either the European Union ($19.18 trillion) or the United States ($18.0 trillion). In any discussion regarding emerging markets, the powerful influence of these two super-giants must be kept in mind.

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. Many funds either follow or try to outperform the MSCI Index. That saves you time. 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.

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. Instead, they spent the extra revenue on subsidies and creation of 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. The governments attracted foreign direct investment by keeping interest rates low. Although this helped increase inflation, it was worth it. In return, the countries received significant economic growth.

In 2013, commodity prices fell. These governments had either 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 that led to mass sell-offs of currencies and investments.

Others invested revenue in infrastructure and education for their workforce. Because their people saved, there was plenty of local currency to fund new businesses. When the crisis occurred in 2014, they were ready. These countries are China, Colombia, Czech Republic, Indonesia, Korea, Peru, Poland, Sri Lanka, South Korea, and Taiwan.