Emerging Market Investment Risks

EMERGING MARKET
INVESTMENT RISKS

Table Of Content
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Emerging Markets – A Brief Overview
Biggest Misconception – GDP and ROI are Correlated
Emerging Markets – Hidden Investment Risks
Emerging Markets – Risk Scenarios
Conclusion

Executive Summary
• An emerging nation is the one which has achieved industrial capacity and is on the verge of becoming an industrialized nation
• It is characterized by its transitional economy, growing young population, underdeveloped infrastructure and growing foreign
direct investments
• They have always been seen as a lucrative destinations for foreign direct investments mainly because of their growing GDP
• This research explores one of the biggest misconceptions relied upon by investors for judging an emerging market potential and
highlights the hidden risks which have to be considered while making an investment decision. The risks include poor governance,
liquidity issues, transfer pricing regulations etc.
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Table Of Content
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Conclusion

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An Emerging nation is the one which has achieved industrial capacity and is on the verge of becoming an industrialized nation. Despite their
rising importance, there is no single definition for defining them.
Characteristics of Emerging Markets (EM)
Transitional Economy: The markets are often in the process of moving from a closed economy to an open market economy. There is also a heightened
political and monetary policy risk.
Young Growing:
• Emerging markets often have younger population with the capacity to spur strong long-term growth rates by replenishing aging workers and increasing
domestic demand for goods
• As per Euromonitor, in FY13 the Emerging markets comprised of 85% of the world’s population , out of which 90% were under the age 30. Further this is
expected to grow three times the rate of developing economies between 2014-2020.
Underdeveloped Infrastructure :
• Emerging markets often have building infrastructural development at nascent stages.
• As per The Royal Bank of Scotland study on 40 major EM economies , it predicted that the demand for infrastructure will reach USD 1 trillion annually by
2030, which will be triple the level of last 20 years, with Asia accounting for the largest share.
Increased Foreign Investment: Emerging Markets usually witness strong foreign direct investment , which is a good sign for anticipated future economic
growth . As per the World Investment Report’ 2014, the FDI inflows to developing economies reached USD 778 billion, which accounted for 54% of the global
inflows.
Key Highlights of the Emerging Markets
EM’s are important bases for global manufacturing operations, at the same time they also enjoy booming export business options
EM’s also benefit from regulatory reforms, cross-border trade, and loose monetary policy. Therefore, the EME’s provide new investment opportunities such
as higher economic growth rates, higher returns and immense diversification benefits. However, there are risks both at residential level and foreign investor
levels.
Source: World Bank, IMF

Emerging Markets – 2014 – Top 20 Countries
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Source: Bloomberg’s Best Emerging Markets 2014

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Conclusion

Emerging Markets – GDP and Returns on Investment
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Biggest Misconception about investing in emerging markets: Faster economic growth will result in higher equity returns compared with developed markets. There
are number of studies that prove that there is no such linkage between GDP and Investment Returns and in most of the cases it is negatively correlated. Below are
some of the findings based on 2013 studies from Goldman Sachs Investment Strategy Group.
Exhibit 1: A Disconnect Between GDP Growth and Equity Returns
*Source: Goldman Sachs Investment Strategy Group
Exhibit 2: Equities in Slow-Growth Economies Have Posted Better Returns Exhibit 2: Exhibit 3: Equities and GDP Growth Diverge in Emerging Markets
The data is as of 2012
• The overall economic growth over the last 32
years, the correlations range from 0.07 to –
0.07.
• Over a 42-year span, the correlation rises to
0.43, but it subsequently drops to zero when
the analysis is extended by one more year.
Key Takeaway: This shows that the
correlations is highly unreliable and unstable.
And the notion that the economic growth and
equity returns are correlated should be
rejected.
• To further elaborate on the first study (Exhibit 1) ,
the analyst devised an investment strategy whereby
the countries were assigned to five quintiles based
on their GDP growth rates over the preceding five
years.
•They show that the total return of stocks in the
countries of the slowest growth quintile exceeded
the total return of stocks in the fastest growth
quintile, whether one looked at 17 countries with
data going back to 1900 or 53 countries going back
over several decades.
Key Takeaway: The slower growth countries
actually outperformed the faster growth countries by
3% a year over the 105-year period.
• The Investment Strategy Group updated the
above analysis from 1988 to 2012 for emerging
market countries. the correlation between equity
returns and the growth rate of GDP per capita is –
0.48 for emerging countries.
Key Takeaway: Stock performance and economic
growth don’t always go hand-in-hand. The data is
as of 2012.
The studies indicate that it is just not enough to consider a market based on its economic or GDP growth prospects. Rather
the investors have to understand the country’s or market’s risk profile and make strategically sound investments to yield
strong returns.

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Conclusion

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TURKEY: The economy is marred by Civil Unrest with
violent protest. Political Leadership is struggling. It has a
current account deficit of 7.5% and inflation is around
7.5%.
UKRAINE: History of corruption and mismanagement.
Business and politics intertwined. Recently due to the
ongoing anti-government protest, the economy has
shrunk by 0.3% in FY13. The economy is struggling
from recession and capital drain.
NIGERIA: The country is facing security challenges
due to Boko Haram , insurgency. The market is
impacted heavily by the violence and rampant spending
on election during election.
Developed Economies
Emerging Economies
Legend
SOUTHEAST ASIA: The FY14 outlook is troubled by
several political risks. One of the key risk will be the
impact of Fed tapering of its quantitative-easing
program and policy driven interest rate in FY15 . There
will a risk of currency depreciation.
SOUTH AFRICA: The economy is struggling with
chronic unemployment and strained labor relations.
EGYPT: The country is witnessing
political uncertainty and violent
protests.
RUSSIA: To condemn the Ukraine Crisis, the US and
European Union have imposed a new economic
sanctions on Russia.
Latin-America: The economy faces the
risk of lower commodity prices due to weaker
demand and volatility in capital flow.
CHINA: The economy faces the risk of slowed
investment growth, increased government debt
and property market risk.
IRAQ: The country faces security challenges
and it is being classified under high risk
investment.
Source: News Articles

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Conclusion

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*ROI – Return On Investment
FOREIGN EXCHANGE COVERSION RISK ON ROI*
IMPOSSIBLE TO FORECAST ROI*
NEGLIGENT INSIDER TRADING RESTRICTIONS
LESS LIQUIDITY
INADEQUATE CAPITAL RAISING MECHANISMS
POOR CORPORATE GOVERNANCE SYSTEMS
INCREASED CHANCE OF BANKRUPTCY
ADVERSE POLITICAL ISSUES
TRANSFER PRICING
Note: The Risks are covered in further detail in the Annexure
Source: PWC, Investopedia, News Articles

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Conclusion

Conclusion
• The highlighted risks are some of the most predominant risks that must be assessed prior to any investments
• The emerging markets insurance regulators, who usually report to Treasury or Finance ministers, are increasingly forcing
multinationals to secure their entire local cover through local insurers. This tactic keeps funds growing with the taxes levied on
the foreign company’s insurance premiums.
• Adding to the vows, are that the local insurers do not carry the same premiums and have an inconsistent approach
• On a positive note, the presence of such hidden risks does not stop companies to make investments in the emerging
markets, since they have immense potential to produce substantial returns. So, the investors should always judge such
potential high returns within the risk and reward framework.
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Emerging Market – Hidden Investment Risk (1/4)
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Foreign investments in stocks and bonds produce returns in local currency of the host. The host currency is often a subject to currency depreciation.
This fluctuation impacts the total investment return.
FOREIGN EXCHANGE COVERSION RISK ON ROI
Illustration:
•An American who purchases a Brazilian stock in Brazil will have to
buy and sell security using the Brazilian real.
•So if the local value of the held stock increased by 5%, but the real
depreciated by 10%, the investor will experience a net loss in terms
of total returns when selling and converting back to US dollars.
•Thus, currency fluctuations can impact the total return of
investment.
There are number of examples that highlights how the currency fluctuations impact the investment returns:
1. Venezuelan Currency Devaluation: Large number of MNCs like Brink, Proctar & Gamble , Colgate companies who were reporting their earnings
in local exchange rate had to write down their business profits after the currency devaluation
2. Renminbi Depreciation: The sudden currency depreciation has raised the investment risks for foreign investors. The Chinese Yuan lost nearly all
of its 2013 appreciation against the US dollars. The currency is expected to further depreciate
3. Brazilian Real Depreciation: The depreciation impacted the Foreign Direct Investments significantly. In 2013, the investments fell to USD 6.5
billion from USD 8.3 billion
Further, in 2013, according to the financial daily Cronista Comercial, the Chilean peso has lost 7.76%; the Peruvian Sol, 6.12%; the Mexican Peso, 6%
and the Colombian Peso, 3.8%. Against the US dollars

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IMPOSSIBLE TO FORECAST ROI
Emerging market securities cannot be valuated using the same type of financial models
used for forecasting developed market securities
This is because the EME’s are undergoing constant changes and it makes it impossible
to utilize historical information to draw proper correlations between the events and
returns
LESS LIQUIDITY
Emerging markets are low on liquidity when compared with the developed markets
This market imperfection results in higher broker fees and increased stock price
uncertainty
NEGLIGENT INSIDER TRADING RESTRICTIONS
Most countries claim to enforce strict laws against insider trading, none have proved to
be as rigorous as America in terms of prosecuting unfair trading practices
Insider trading and various forms of market manipulation introduce market
inefficiencies, which results in significant deviation of equity prices from their intrinsic
value

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INADEQUATE CAPITAL RAISING MECHANISMS
•Emerging markets have poorly developed banking system, which prevents firms from
having proper access to finance. This hampers its investments and growth.
POOR CORPORATE GOVERNANCE SYSTEMS
•Emerging markets sometimes have weaker corporate governance system, whereby
management, or even the government, has a greater voice in the firm than the
shareholders
•Furthermore, when countries have restrictions on corporate turnovers, management
does not have the same level of incentive to perform in order to maintain job security
ADVERSE POLITICAL ISSUES
•Political risk refers to uncertain adverse political decisions
•Developed economies tend to follow a free market discipline of low government
intervention whereas emerging market businesses are often privatized upon demand
•Some additional factors that contribute to the emerging market political risk are:
possibility of war, tax increase, loss of subsidy, change of market policy, inability to
control inflation and laws regarding resource extraction
•Major political instability can also result in civil war and a shutdown of industry, as
workers either refuse or are no longer able to do their jobs

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INCREASED CHANCE OF BANKRUPTCY
•Lack of good system of checks and balances combined with weaker accounting audit
procedures increase the chance of corporate bankruptcy.
•The emerging markets are seen as risky investments, in order to attract investors they
will have to issue bonds that pay higher interest rates.
•The increased debt burden further increases borrowing costs and strengthens the
bankruptcy potential.
TRANSFER PRICING
•According to EY’s 2013 Global Transfer Pricing Survey, about 66% of the MNCs
identified risk management for transfer pricing in emerging markets as their top priority
which is up by 32% from 2010.
•Transfer pricing risk is about being subject to an audit on intercompany transactions
and the government tax offices trying to grab as much share as they can of the income
derived from an organization’s cross-border transactions, mainly by double taxation.
•Therefore, any difference in principles and application of transfer pricing regulation
between two countries can result in serious issues for the company.
•Non-compliance to country’s transfer pricing rules and regulations also attracts
penalties.

Emerging Market Investment Risks

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