Frontier markets have great potential, but come with a unique set of risks.
It should be abundantly clear that I believe frontier markets, if governed properly, will become emerging markets and, eventually, developed markets. This 2016 article in Forbes makes the case that frontier markets offer undiscovered gems to investors, as long as you are patient.
But, there are risks.
As I explain in my book, “Frontier Investor: How to Prosper in the Next Emerging Market,” when I look at an investment opportunity, I analyze its risks across three categories: political, macroeconomic, and microeconomic. This structured risk assessment is especially important in frontier markets, where governments and economies are often at very early stages of development or in a period of faster-than-usual (by developed markets standards) fluctuation.
Here, I’ll dive into each category in order to shed some light on what to look for when assessing the risk factors inherent to frontier markets.
Category One: Politics
The political situation in any country plays a huge role in the economic stability, and viability of that country.
My favorite example: North Korea and South Korea.
In 1945, when the country was arbitrarily split, both Koreas had the same culture and language and were similar size. The South’s economy and population both were about twice the size of the North’s, but the GDP per capita was almost identical. South Korea was predominantly agricultural, while most of the natural resources, hydroelectric power, and manufacturing were in the North.
Yet today, South Korea’s GDP per capita is nearly twenty times that of North Korea. The principal cause for this vast discrepancy is politics.
What is political risk? It’s the uncertainty of return on capital (or even return of capital) due to government actions, including:
- Ability to repay, but lack of desire to repay, debt
- Expropriation of privately held assets
- Citizen reactions to policies (demonstrations, sit-ins, riots)
To truly assess the risk it’s important to have “boots on the ground” information. Meetings with elected officials to determine what their actions are, or will be, rather than believing the rhetoric or the headlines are tremendously helpful.
Another option is to visit the country, or have trusted colleagues in place, who can tell you if the thousands of demonstrators were really only 100, and the incident isolated.
Category Two: Macroeconomics
Macroeconomic risks include inflation, currency and systemic risks that spill over from events in developed markets (think of the U.S. housing bubble that burst in 2008.)
Inflation can present in two ways. It’s either expected, which causes no additional risk, or unexpected and often caused by rising commodity prices. In particular, it’s important to be aware of price swings in food and oil.
Currency risk is the risk that investments held in foreign currencies will lose money due to fluctuating exchange rates.
You can avoid frontier market currency risk altogether by investing only in your home currency. This is actually easier to do in frontier debt markets, where most bonds are denominated in hard currencies (mainly the U.S. dollar, the euro, and the yen).
Also, most frontier market direct equity investments can be made only in their local currency.
Category Three: Microeconomics
Microeconomic risks include market liquidity as well as custody and settlement risk.
By definition, most frontier markets are smaller and often much less liquid than mainstream emerging markets or developed markets.
This presents two specific challenges. First, an illiquid market may force you to pay more than you would like for a stock, or may even keep you from buying that stock altogether. The second problem, selling, can range from being forced to sell at a much lower price than you’d like or, the worst case scenario, not being able to sell at all because the market is shut down (as happened in both Egypt and Greece.)
Custody and settlement
This encompasses an assortment of uncertainties investors face when attempting to buy, hold, and sell securities in frontier markets. Custody risk is the risk of loss if the custodian holding your investments:
- files for bankruptcy
- goes out of business
- otherwise loses or absconds with your assets
Settlement risk (which bookends custody risk) is the risk that the securities you paid cash for are not delivered, or that you are not paid the cash for securities you delivered.
Settlement risks outside of custodian bankruptcy arise from:
- antiquated processes and technology (increasingly rare)
- human error or malfeasance
- disruptions on the local exchange due to downed networks, power outages, political actions, natural disasters, etc.
Given that each country has its own rules, laws, regulatory mechanisms and level of enforcement, the best way to protect against custody and settlement risk is due diligence and rigorous monitoring. The best way to handle that is in country, person-to-person, if at all possible.
Marko Dimitrijevic is a leading expert on emerging markets. An entrepreneur, investor, photographer, and public speaker, Marko is the author of Frontier Investor: How to Prosper in the Next Emerging Markets, which is available on Amazon.