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Emerging markets: Advantages and disadvantages of investing

Emerging Markets

Securities of emerging markets already became an independent and quite numerous class of assets. During the recent years governments and corporations of these countries increasingly feel the need for capital and use equity and debt instruments (instead of traditional Bank loans) to finance their plans. This naturally leads to qualitative and quantitative growth of local financial markets: the numbers of issuers, tradable shares and bonds, trading volumes are increasing.

According to some estimates, by 2020, the market capitalization of emerging markets could triple and reach 17.4 trillion USD, and their share in total capitalization of stock markets of the world will grow from the current 14 % to 24 %.

The current growth of interest of investing in emerging markets is observed due to significant improvement in their fundamental characteristics. Many of the EME-countries run a tight monetary policy, fight inflation, and strive to maintain a balanced budget. Also they try to create favorable conditions for attracting foreign capital. In favor of emerging markets says the actions of the international rating agencies that respond to the improving macroeconomic situation in these countries by improving their credit ratings. In addition, the inclusion in the investing in emerging markets or securities may have a number of advantages:

Emerging Stock Markets

Diversification. Between developed and emerging stock markets there is no strong correlation, and sometimes they move in different directions. Therefore, the inclusion in the portfolio of both asset classes makes it more balanced.

Profitability. Purchasing securities of emerging markets allows increasing the potential profitability of the portfolio by increasing its riskiness. It has been noted above that in recent years emerging stock markets are growing more rapidly than developed. Although, such superiority is not considered as a rule.

Undervaluation. Many studies explore the relative cheapness of the assets of the emerging markets. Thus, according to S&P/Citigroup Global Equity Indices, at the end of September of this year, stocks of emerging markets had price/earnings ratio of 13.3, while the average for American stocks was 21,0.

Now let's take a look at the reverse side of the coin — the risks associated with investing in emerging stock markets. Their classification might look as the following.

Political. In the news pertaining to the situation in developing countries you will often see words like "political conflict", a "currency crisis", "social protest". The change of government could lead to a radical course correction of economic policy, even up to "reversal". And this is a threat of nationalization, revision of privatization results, closures, etc. As a result, the collapse in the local financial market is provided.

Financial. Firstly, these are the risks posed by the 'fragility' of local currencies. Earned by operations with foreign securities, the profit may be offset by unfavorable changes in currency exchange rate. Secondly, there are risks associated with existing and future monetary restrictions (convertibility of the national currency, the order of the divestments and profit repatriation by non-residents, etc.).

Systemic. Significant risks create a small capacity of the emerging markets. There are more than 120 countries in the world, which belong to the category of EME, but do not think that such a huge number of countries means a myriad of investment opportunities. Suffice it to say that not all developing countries (only a third) have the national stock market. We also refer here risks associated with the fragile infrastructure of the market, local brokers, the speed and correctness of orders execution.

Investment. It is worth mentioning, that the emerging markets have a weak immunity, and are very sensitive to external factors. For example they usually have stronger reaction to negative news. It is important to note that emerging market securities, despite their heterogeneity, are considered as one asset class. This means that problems in one EME-the country can immediately lead to capital flow from the all emerging markets.

By Chieffinancing 25.07.2016

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