What Is an Emerging Market Economy?

An emerging market economy (EME) is defined as an economy with low to middle per capita income. The term was coined in 1981 by Antoine W. Van Agtmael of the International Finance Corporation of the World Bank.

Although the term „emerging market“ is loosely defined, countries that fall into this category, varying from very big to very small, are usually considered emerging because of their developments and reforms. Hence, even though China is considered one of the world’s economic powerhouses, it is lumped into the category alongside much smaller economies with a great deal fewer resources, like Tunisia. Both China and Tunisia belong to this category because both have embarked on economic development and reform programs, and have begun to open up their markets and „emerge“ onto the global scene. EMEs are considered to be fast-growing economies. Here’s an overview of the GDPs of nations all of the world.

What an EME Looks Like

EMEs are characterized as transitional, meaning they are in the process of moving from a closed economy to an open market economy while building accountability within the system. Examples include the former Soviet Union and Eastern bloc countries. As an emerging market, a country is embarking on an economic reform program that will lead it to stronger and more responsible economic performance levels, as well as transparency and efficiency in the capital market. An EME will also reform its exchange rate system because a stable local currency builds confidence in an economy, especially when foreigners are considering investing. Exchange rate reforms also reduce the desire for local investors to send their capital abroad (capital flight). Besides implementing reforms, an EME is also most-likely receiving aid and guidance from large donor countries and/or world organizations such as the World Bank and International Monetary Fund.

One key characteristic of the EME is an increase in both local and foreign investment (portfolio and direct). A growth in investment in a country often indicates that the country has been able to build confidence in the local economy. Moreover, foreign investment is a signal that the world has begun to take notice of the emerging market, and when international capital flows are directed toward an EME, the injection of foreign currency into the local economy adds volume to the country’s stock market and long-term investment to the infrastructure.

For foreign investors or developed-economy businesses, an EME provides an outlet for expansion by serving, for example, as a new place for a new factory or for new sources of revenue. For the recipient country, employment levels rise, labor and managerial skills become more refined, and a sharing and transfer of technology occurs. In the long-run, the EME’s overall production levels should rise, increasing its gross domestic product and eventually lessening the gap between the emerged and emerging worlds.

Portfolio Investment and Risks

Because their markets are in transition and hence not stable, emerging markets offer an opportunity to investors who are looking to add some risk to their portfolios. The possibility for some economies to fall back into a not-completely-resolved civil war or a revolution sparking a change in government could result in a return to nationalization, expropriation and the collapse of the capital market. Because the risk of an EME investment is higher than an investment in a developed market, panic, speculation and knee-jerk reactions are also more common — the 1997 Asian crisis, during which international portfolio flows into these countries actually began to reverse themselves, is a good example of how EMEs can be high-risk investment opportunities. (For more insight on getting into emerging economies, read Forging Frontier Markets.)

However, the bigger the risk, the bigger the reward, so emerging market investments have become a standard practice among investors aiming to diversify while adding risk. (For more details on the advantages and disadvantages of making foreign investments, see Is Offshore Investing For You? and Going International.)

Local Politics vs. Global Economy

An emerging market economy must have to weigh local political and social factors as it attempts to open up its economy to the world. The people of an emerging market, who are accustomed to being protected from the outside world, can often be distrustful of foreign investment. Emerging economies may also often have to deal with issues of national pride because citizens may be opposed to having foreigners owning parts of the local economy.

Moreover, opening up an emerging economy means that it will also be exposed not only to new work ethics and standards but also to new cultures. The introduction and impact of, say, fast food and music videos to some local markets has been a by-product of foreign investment. Over the generations, this can change the very fabric of a society, and if a population is not entirely trusting of change, it may fight back hard to stop it.

The Bottom Line

Although emerging economies may be able to look forward to brighter opportunities and offer new areas of investment for foreign and developed economies, local officials in EMEs need to consider the effects of an open economy on citizens. Furthermore, investors need to determine the risks when considering investing in an EME. The process of emergence may be difficult, slow and often stagnant at times. And even though emerging markets have survived global and local challenges in the past, they had to overcome some large obstacles to do so.

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