Why have some equity markets in the developing world flourished more than others? It’s a pivotal question for investors hoping to stake an early claim to the potential emerging-market (EM) success stories of the next decade.
It is also vital for gaining a better perspective on the recent market turmoil in Turkey, Ukraine and Argentina, which has sparked fears of a sweeping 1990s-like EM crisis. The developing world has become far more diverse over the past decade, and clear distinctions among individual EMs have surfaced. For long-term investors, the need to discriminate has never mattered more.
Though the pace of development in emerging countries has varied, decades of academic and on-the-ground research show that the most advanced EM capital markets have typically benefited from the same macroeconomic trends that support sustainable economic growth—namely, high rates of domestic investment spending, contained inflation, fiscal balance and openness to foreign capital. Confidence in the stability of a country’s economic and political conditions makes investors more willing to commit long-term risk capital to companies through stocks and bonds.
But while the size and general vigor of an economy are essential building blocks for equity-market progress, they are not necessarily sufficient on their own. After all, Argentina and Nigeria rank among the largest economies in the world, but their market capitalizations are only 9% and 16% of GDP, respectively, compared with the global average of about 65%.
Reformist policymaking has also been critical EM countries with the most robust equity markets have taken steps to control public finances, ensure reliable sources of tax revenues, invest in modern trading systems and capabilities, and establish broad institutional reforms—notably, laws that improve and protect the quality of contracts, minority shareholder rights, regulatory/supervisory oversight, and accounting and disclosure standards. Privatization programs have increased the supply of publicly listed companies, while pension reforms and openness to foreign investors have spurred greater demand for equities.
The Display below traces the key milestones in South Africa’s journey from frontier to mainstream equity market. The turning point in South Africa’s modern history was, of course, the end of apartheid in 1994, which brought profound changes across every level of society and significantly reduced perceptions of political risk. The Johannesburg Stock Exchange (JSE) is currently the largest stock market in Africa and the 18th largest in the world, despite South Africa’s far less auspicious rankings as 29th largest in terms of nominal GDP and 76th largest in GDP per capita. The country’s equity-market capitalization has increased roughly fivefold since 1994. This growth surge has faltered since 2007, as crisis-induced outflows from developing markets have coincided with the country’s economic slowdown and greater competition from other major stock exchanges battling for global market share. Nonetheless, the JSE’s continuing technological investments have enabled it to remain competitive and to continue to expand.
Many developing countries outside of the 12 largest EM nations have the requisite potential for sustainable economic growth. But most of them are dominated by a narrow set of industries and/or don’t have enough companies of sufficient size to attract most institutional investors. Many of these EMs have restrictions on foreign ownership, onerous registration processes and complex trading protocols. In many cases, they present less stable political and macroeconomic settings than do the more established EMs.
But changes are afoot. For example, some of these governments have begun to adopt pro-market, pro-business policies in order to promote private investment and ease foreign-ownership restrictions. A number of African countries that are too small to support their own exchanges have recently banded together to form regional bourses and to upgrade trading technologies.
History shows that equity markets in developing countries tend to deepen after improvements in both macroeconomic and microeconomic conditions make them attractive investment destinations. These are the signposts of transition to watch for.
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