Balancing opportunities and risks in emerging markets

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Investors must adopt a nuanced approach that combines thorough research, risk management and strategic partnerships, writes Arunima Sharan, Senior Economist, Economic and Monetary Policy Institute at OMFIF.

In the ever-evolving landscape of global finance, emerging markets represent both promising opportunities and complex challenges. These economies – characterised by rapid growth, young populations and developing financial systems – offer a compelling proposition for investors seeking diversification and potentially higher returns, but also a complex tapestry of risks.

This edition of the Bulletin, through insights from the public and private sector, explores the case for investing in emerging markets, the associated challenges as well as the roles of multilateral and in-country actors to facilitate investment in key sectors.

As emerging markets now contribute over half of the world's gross domestic product, their significance in the global economy is undeniable. The case for investors to reconsider allocation to emerging markets is argued by Massimiliano Castelli and Philipp Salman, strategy and advice, global sovereign markets at UBS Asset Management, who point to  positive growth differentials between emerging and advanced economies, improved macroeconomic stability and better policy management. On the asset allocation front, they also ‘expect EMs’ assets to outperform in the next decade with EM debt (in hard currency) generating higher annual returns than global equities (with less volatility)’.

The maturation of debt markets in emerging markets has created a sub-asset class worth nearly $4tn, offering a diverse range of investment instruments across various sectors. Jeremy Cunningham, investment director at Capital Group, emphasises the strategic imperative of considering an allocation to local currency debt in emerging markets, noting that EM local currency benefits from diversification, greater variety of debt instruments, greater liquidity and the potential for higher returns.

Investing in EMs, however, comes with higher risks, including currency volatility, political uncertainty and sovereign default, necessitating extensive research and active management.

Yet, the global macroeconomic environment plays a crucial role in shaping investment prospects in emerging markets. Jeffery Schultz, chief economist, central and Eastern Europe, Middle East and Africa at BNP Paribas notes that while growth in emerging markets has been buoyed by strong activity in the US and a gradual European recovery, these factors help offset a weaker Chinese economy. However, inflation remains a concern, with forecasts indicating that central banks may not meet targets until 2025.

Adding to the trickier trade-offs, fiscal policy in emerging markets is expected to gain relevance, especially following key elections in these emerging economies. Recent elections in South Africa, Mexico and India have tested investor nerves, as observed by Christopher Smart, managing partner at Arbroath Group, who writes about the delicate balance between voter demands and market constraints. These political shifts can lead to populist policies that jeopardise fiscal and monetary stability, impacting disinflation progress and asset prices.

To mitigate some of the risks, Joon Park, senior manager, blended finance at the International Finance Corporation, explains how blended finance reduces risks and mobilises larger volumes of private capital in emerging markets. He writes, ‘by absorbing risks that private investors are unwilling to take on, blended finance multiplies the impact of limited public resources, mobilising larger volumes of private capital’.

Similarly, Manfred Schepers, chief executive officer of ILX Fund I, explains that multilateral development banks are well placed to address challenges in emerging markets due to their investment experience, local network, sector expertise and financial capacity. Institutional investors can greatly benefit from this expertise, as ‘co-financing alongside MDBs is not only necessary, but also a smart business decision’ – particularly in the area of climate finance.

While the presence of multilateral actors goes a long way in facilitating investments in emerging markets, domestic institutions and the policy environment are also crucial. Arief Budiman, deputy CEO of Indonesia Investment Authority, highlights the role of sovereign funds in attracting global institutional investors to emerging markets, noting for example, how INA acts as a co-investor, leveraging local knowledge and networks to facilitate investment from global partners focusing on sectors such as the energy transition and digital infrastructure.

Elsewhere, in India, K Mukundan, strategic initiatives and policy advisory at the National Investment and Infrastructure Fund highlights opportunities arising from the country’s green and energy transition, which is being supported by policy incentives and infrastructure development. He points out that, ‘India's dual focus on economic growth and environmental preservation positions it as a global leader in sustainable development’, making it a compelling investment destination.

Investing in emerging markets offers some attractive opportunities for growth, diversification and impact. However, these opportunities come with significant challenges, including political risks, economic volatility and complex regulatory environments. To navigate this terrain successfully, investors must adopt a nuanced approach that combines thorough risk management and strategic partnerships. Blended finance and collaboration with development finance institutions offer promising avenues for mitigating risks and accessing the full potential of emerging markets.

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