Asset Management

Frontier Markets: The Emerging Markets of Tomorrow

Miroslav Durana, Credit Suisse, 19 March 2008

articleimage

Although the BRIC economies were very underdeveloped throughout the 1980s and 1990s, in recent years they have particularly benefitted from the global economic growth as a result of globalisation.

Although the BRIC (Brazil, Russia, India, and China) economies were very underdeveloped throughout the 1980s and 1990s, in recent years they have particularly benefitted from the global economic growth as a result of globalisation.

The commodities boom in Brazil and Russia and the competitive advantages enjoyed by China has led to strong capital inflows, as well as a healthy balance of payment surpluses. Amongst other things, this is reflected in the substantial increase of foreign currency reserves held by these countries with BRIC countries now accounting for around 38 per cent of the world's measurable foreign currency reserves.

The BRIC countries have also proved to be the key driver of global economic growth with the average real gross domestic product growth of these countries amounting to 7.5 per cent for the last five years. Official estimates from the IMF suggests the BRIC nations will account for 31 per cent of global economic growth in 2008.

Financial services providers and the international investment community acknowledge the strong growth in these countries. As a result, the allocation of resources to these countries has expanded significantly. While the BRIC countries accounted for just 4 per cent of global market capitalisation at the end of 2003, they now account for more than 14 per cent which matches their proportion of global GDP (14 per cent, up from 9 per cent in 2003).

However, the boom in emerging market investment has also led to an increase in valuations, and in 2007 the MSCI Emerging Markets Index finally eliminated the valuation discount to the MSCI World Index (as measured in terms of P/E ratios). Even though we are expecting real GDP growth of +6.5 per cent for the emerging markets in 2008 (compared to +1.5 per cent for the US and Europe), this attractive growth profile is for the most part already priced in to current equity valuations.

A consequence of the rapid economic growth and increased financial stability of emerging markets is not just seen in their economic profiles but also in their stock valuations which are converging with those of traditional developed economies.

Investors willing to continue their exposure to business and financial developments at the lower end of the development chain, as well as those wanting to maximise the global diversification of their portfolios, should now invest in frontier markets.

Frontier Markets on the Threshold of a Growth Spurt
Frontier markets are countries which are still in the very early stages of economic development. To be classified as a frontier market, the economic strength of the economy as measured by GDP per capita must be below $10,000. In addition, the markets in question must have a relatively low level of financial market penetration. This can be gauged by comparing national market capitalisation to national GDP. Whereas the figure in traditional emerging markets is already high, the BRIC average is 136 per cent, whereas many frontier markets have equivalent figures of less than 50 per cent.

But not all countries that fulfill these criteria are classified as attractive frontier markets with the potential to become the investment markets of tomorrow.

For a country to be selected as a frontier market, it needs to have the correct overall profile in terms of the following four other aspects: (i) macroeconomic potential, (ii) well-being and education of population, (iii) development of financial markets, (iv) political stability.

In terms of the indicators for "well-being and education" and "political stability", reference has been made to indices published by international organisations such as the UN and the World Bank. Examples of attractive frontier markets include Vietnam, Kazakhstan, and Peru.

These economies are characterised by low income per capita, high economic growth, highly developed legal frameworks, and geopolitical stability. At the same time, the financial markets of these countries are still in the early stages of development. As long as the geopolitical parameters continue to develop favourably, Credit Suisse believes these frontier market economies will continue to develop in an extremely dynamic manner, which will contribute to increase their appeal to the international investment community.

Tapping into Frontier Market Potential
Investors who gain exposure to frontier markets at an early stage are likely to reap greater rewards, as many of these markets have so far slipped under the radar of investors and financial intermediaries, or have simply been inaccessible.

The best way to tap into frontier market potential is through investments in listed companies that generate the majority of their earnings in frontier markets and are also headquartered in these markets.

These companies should either be listed on the local stock exchanges, or accessible via American Depository Receipts. The launch of the Credit Suisse Frontier Market Index allows simple access to the growth potential of these markets for all equity investors. The index methodology involves a regular rebalancing that ensures the index always contains stocks that are most exposed to frontier market growth. Once a given frontier market reaches the development level of the current BRIC nations, the stocks of this country are removed from the index and replaced by others as applicable.

All economies go through different phases of economic development as part of their natural evolution. At the start of economic development, basic needs such as food, clothing, accommodation, and communications are required.

The frontier markets are still at this stage. In the second development phase, the population accumulates assets, which in turn leads to a strong increase in demand for retail banking services.

Traditional emerging markets are either at this phase already or even at the next one, where a consumer society emerges on the back of rising per capita income.

The emergence of a consumer society involves increased demand for brand names and lifestyle products. Once an economy has reached this stage which is the latest in development, the companies that are domiciled in the country in question are removed from the universe of the Frontier Market Index.

In the final phase, once the middle class and the per capita income of a country has reached a critical mass, there is increased demand for luxury goods and services such as jewellery, expensive cars, and holidays. Throughout these stages of economic development, massive investment in infrastructure becomes necessary and the resource requirements of these countries is likely to increase dramatically.

Register for WealthBriefing today

Gain access to regular and exclusive research on the global wealth management sector along with the opportunity to attend industry events such as exclusive invites to Breakfast Briefings and Summits in the major wealth management centres and industry leading awards programmes