emerging market investment risks

EMERGING MARKET

INVESTMENT RISKS

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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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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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ANNEXURE

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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

Economy & Finance