The Emerging Markets asset class, for both bonds and equities, is made up of a smorgasbord of countries that don’t have much to do with one another. Very broadly, the index providers (MSCI, FTSE, Russell, etc.,) differentiate between developed, emerging and frontier markets in terms of “investability” criteria, such as market capitalization, liquidity and transparency. In this article, we provide a framework to further categorize emerging markets. We look first at the basic economic structure of countries: the growth in the quantity of labor and the expected growth in the productivity of that labor. Second, we look at the capacity of countries to compete and move up value chains in a global economy.
1.Economic Structure
First, in the chart below, we look at GDP per capita, the most basic measure of a country’s relative development. We see that Taiwan, Korea and perhaps Poland are really closer to developed countries on this measure. Then , moving from left to right on the chart, we can somewhat arbitrarily group the other countries into middle-income (Chile to Thailand) and lower income (Peru to India).
Second, in the chart below, we distinguish between dynamic, stagnant and languid economies by measuring how GDP per capita for each country has evolved relative to the United States since 1980. Dynamic economies are converging with United States, the stagnant ones are “trapped” in relative terms and the languid ones are falling behind. The term “Middle-Income Trap” refers mainly to middle-income countries in Latin America that have stopped converging over this period, but there are also rich and poor countries that are neither outgrowing or growing less than the United States.
The following chart shows the long term effect of convergence for dynamic economies (Korea and China) and a “trapped” country (Brazil). India has recently started a process of convergence, but it remains to be seen for how long it can be sustained.
GDP growth can be broken down into the growth of the supply of labor and the growth in the productivity of labor. The following three charts provide insight into labor growth for different EM countries: first, the expected annual growth in the working age population for the next decade; second, the degree of urbanization; and third, the female participation rate. These charts show radical extremes: On one end, a country like India ,with a growing population, very low urbanization and very low female participation, has potentially very large employment growth; at the other end, Korea , with negative growth in the working age population, a high degree of urbanization and a high rate of female participation, is likely to have very low employment growth.
In addition to the growth in the quantity of labor we need a notion of labor productivity growth. The chart below shows annual labor productivity growth for the past ten years, which is a valid starting point for estimating future productivity growth.
Not surprisingly, labor productivity is linked to capital formation, as shown in the following chart.
Assuming that these rates of productivity growth persist in the future (admittedly a big assumption) and adding these to the working age population growth, we can derive a very general idea of potential future growth, which we show in the next chart.
2.Competitiveness
Another distinguishing characteristic of countries is the conditions they offer for private capital to unleash its entrepreneurial drive (“animal spirits) ,to boost productivity and innovation. These conditions — Economic Freedom (The Heritage Foundation), or “Ease of Doing Business” (World Bank) — require good governance and an efficient bureaucracy which provides rule of law, infrastructure and social services (education, healthcare). The result of good governance is a dynamic entrepreneurial sector which is innovative and globally competitive.
For countries to become increasingly competitive in the global economy they need 1. Human Capital; 2. Innovation and economic complexity; and 3. Growing participation in world trade for manufactured goods.
Human capital (education, health, etc.,) is measured by the World Bank’s Human Capital ranking. Also, the OECD’s PISA (Program for International Student Assessment) provides an indication of the educational achievement levels of many countries. Both of these are shown below.
Economic Freedom has been measured by the Heritage Foundation, the World Bank (Ease of Doing Business) and the World Economic Forum, among others, always with the objective of appraising the conditions for private investment and entrepreneurship. Below, we provide some of the findings of the Heritage Foundation’s Economic Freedom Index.
Innovation and Economic Complexity both are important indicators of a
country’s potential for moving from middle-income to higher-income status. Many EM countries, particularly those in Latin America, have not been able to innovate and move up industrial global value chains, falling into the “Middle-Income Trap.”
The Bloomberg Innovation Index ranks the major economies of the world in terms of innovation capacity. As usual, it is important to understand the historical trends of the indicator. The two charts below show the latest innovation rankings and the evolution of the rankings for the United States and China.
The Economic Complexity Index (ECI) measures the knowledge intensity of an economy. The first chart shows the rankings for a sample of major developed and EM economies. The second chart shows the evolution of the index since 1998 for three “converging” countries (China, Korea and Poland) and two laggards (Brazil and the U.S.). Both the U.S. and Brazil are major commodity producers vulnerable to the “natural resource curse.”
Participation in World Trade is another critical indicator of competitiveness and growth potential. The evidence throughout history points to a clear connection between trade and prosperity. In the following two charts we contrast convergers with commodity producers. The convergers (China, Taiwan, Korea, Poland) have grown their participation in world trade while the commodity producers have low (and very volatile) participation.
Conclusion
From a macro viewpoint emerging markets include countries with very different profiles. In the chart below, we show which countries do well in growth and competitiveness. Hypothetically, the countries with growing economies that are competitive in a global economy should be attractive for investors. Unfortunately, many other factors come into play, the most important of which is the capacity for corporations to accumulate capital over long periods of time through high profitability and reinvestment opportunities. It is also important to understand financial stability and pay great attention to debt cycles, foreign flows and balance of payment dynamics.
