Frontier versus major emerging markets; differences in definition and vulnerabilities

In our annual update of the KBC Sustainability Barometer, we note that EMs “are generally characterised by strong inflows of foreign direct investment, a high degree of industrialisation and substantial openness to external international markets… such countries are often in a major state of transition, with prosperity levels (per capita GDP) that, while rising rapidly, are usually lower – and significantly so in some cases – than those in developed countries.” From this broad and very generalized description, we can pull out some criteria used to classify EMs.

The first is income per capita, with high-income economies generally seen as developed or advanced. But there are important distinctions to be made between, e.g., low-income and upper-middle income economies. The IMF classifies countries into developed, transition, and developing economy groups, as well as into four income groups.¹ Based on these classifications, there is a clear link between income and development status, but it is not one-to-one. E.g., transition economies are mostly upper-middle-income economies, and the “least developed” economies within the developing economy group are generally low-income or lower-middle-income economies. But within the larger category of developing economies, there is a mix of low, lower-middle, upper-middle, and even high-income economies.

To differentiate between these very different country groups, we must also think of other factors, such as openness to international markets or foreign investment, and improving infrastructure and institutions. MSCI, e.g., classifies economies into developed, emerging, and frontier markets based on three criteria: GNI per capita, size and liquidity of market, and market accessibility. This results in a narrower set of 25 EMs and a separate set of 21 frontier economies, where frontier economies have even more limited accessibility and liquidity.² JP Morgan’s flagship EM bond index (EMBI Global), on the other hand, doesn’t distinguish between emerging and frontier economies, but those smaller, less accessible, and less liquid markets have a much smaller weight in the index.³

Differentiating between developing economies in this way is useful for several reasons. Of course, it is important to stress that from a social and development point of view, crises in all developing markets are significant and should be a major concern for global leaders and policymakers. This is especially true nowadays, when China has become the world’s largest creditor, largely to low-income, frontier economies, miring global debt statistics in a lack of transparency and raising concerns about how China might work with other creditors when sovereign debt defaults arise. But a crisis in a major EM that is more integrated into the international financial system is more likely to have a significant market impact globally with important spillover risks to other markets or the world economy. Crises in lower-income or frontier markets also carry this risk, but to a much smaller extent. Similar arguments can be made for crises in economies with well-documented, idiosyncratic economic or financial market problems. Investors should be well aware of the higher risk associated with such assets, and increased turmoil there shouldn’t necessarily lead to a change in investor sentiment toward EMs as a whole.

In the present context, the distinction is crucial. EMs currently face important headwinds given high debt levels, rising interest rates, a strong US dollar and high inflationary pressures. Furthermore, the recent IMF bailouts or bailout discussions for at least three EMs (Sri Lanka, Zambia and Ghana) have made headlines and raised the spectre of concern about EMs overall. At the same time, it is important to keep in mind specifics about these economies. All three are lower-middle income economies, classified as either frontier markets (Sri Lanka) or not classified (Zambia and Ghana) by MSCI, and have very small weights in the EMBI global (Ghana 0.56%, Sri Lanka 0.28%, and Zambia 0.14%). On top of this, each economy faces its own specific challenges that contributed to the need for a bailout.

For major EMs, the situation is somewhat different. Current account deficits have generally widened given energy and food price shocks but are still more manageable compared to the crises of the 1980s (Latin America) or 1990s (emerging Asia) (figure 1). The same is true for external debt relative to exports (figure 2). Reserve coverage relative to external debt is also largely adequate according to IMF standards (fully covering short term debt). On top of these fundamentals, major EM central banks have been quick to respond to the inflation threat with policy tightening. Hence, while it is true that the current macroeconomic landscape is anything but friendly—particularly for lower-income economies dealing with a heavy debt load on top of sky-high inflation—an IMF bailout for one EM does not necessarily mean a crisis is coming for all EMs. Specificity is, therefore, more important now than ever.

^{1. World Economic Situation and Prospects 2022 (un.org)}

^{2. Market Classification - MSCI}

^{3. JP Morgan EMBI Monitor September 2022}