What it means
Classification usually rests on a mixture of income per head, the size and accessibility of the local stock market, how easily foreign investors can move money in and out, and the quality of the regulatory system. A country can be wealthy and still be classified as emerging if its markets are hard for outsiders to use.
The category matters commercially because enormous sums track indices built around it. When a country is upgraded or downgraded between developed, emerging and frontier status, index funds must buy or sell its shares, which moves prices regardless of any change in the underlying businesses.
For companies rather than investors, the label is a shorthand for a different operating environment. Expansion into these markets can bring rapid revenue growth alongside currency volatility, less predictable contract enforcement and occasional restrictions on moving cash across borders.
The financial response is normally an adjustment to the discount rate. Analysts add a country risk premium to the cost of equity, so a project in a higher risk country must clear a higher hurdle to be approved.
An important nuance is that the group is far from uniform. The countries inside it differ enormously in stability, depth of capital markets and dependence on commodity prices, so treating them as one block hides most of what matters.
The label is also a moving target. Countries graduate to developed status, slip back towards frontier classification, or spend years on a watch list, so a portfolio or a strategy built on the category needs reviewing as the definitions themselves change.
In practice
Real-world examples.
Example
A European retailer opens stores in South East Asia and grows sales 25% a year while its domestic business grows 2%. The finance team discounts those cash flows at a higher rate, and the project still clears the hurdle comfortably.
Example
A pension fund allocates 8% of its equity holdings to an emerging market index fund for diversification. When the country weightings change after a reclassification, the fund's exposure shifts without any decision by the trustees.
Example
A mining group operating in a frontier economy faces new limits on repatriating dividends. Cash builds up in the local subsidiary, so the parent revalues the investment to reflect money it cannot readily bring home. Its next appraisal model treats trapped cash as worth less than cash in the parent's own bank account, which changes the ranking of future projects.
Think of it
“Emerging markets are developing countries becoming more modern-offering growth but also more risk.
Formula
Calculation
Cost of equity in an emerging market = Risk-free rate + Beta x Equity risk premium + Country risk premium. Consider a consumer goods company assessing a factory abroad, using a risk-free rate of 4%, a beta of 1.1, a mature market equity risk premium of 5.5% and a country risk premium of 3.5%. The calculation is 4 + 1.1 x 5.5 + 3.5 = 4 + 6.05 + 3.5 = 13.55%. The project must therefore return more than 13.55% to create value, against roughly 10.05% for the same project at home.Case study
Seen in the real world.
Calder Beverages is an invented drinks manufacturer used here to illustrate the point. After a decade of flat sales at home, its board approved a $90,000,000 bottling plant in a fast-growing emerging economy, using the group's standard 10% hurdle rate.
Volumes met forecast, but the local currency weakened by around 30% over three years and import duties on concentrate rose twice. Translated into the reporting currency, returns came in at roughly 8% rather than the 16% modelled, and the project sat below its true cost of capital once country risk was included.
Calder did not withdraw. It reworked its appraisal process to add an explicit country risk premium, moved concentrate production into the same country to reduce currency mismatch, and staged its next expansion in three tranches with review points. This illustrative sequence shows that the problem was not the market but the failure to price its risk before committing.
Watch out
Common mistakes.
- Applying the same hurdle rate to overseas projects as to domestic ones, which quietly favours the riskier investment.
- Treating emerging markets as a single homogeneous group when the countries within it differ enormously in risk and structure.
- Modelling growth carefully while ignoring whether profits can actually be converted and moved out of the country.
Questions
People also ask.
How is an emerging market officially defined?
Index providers publish criteria covering income levels, market size, liquidity and accessibility, and they review classifications periodically.
What is a frontier market?
A smaller and less accessible category sitting below emerging status, typically with thinner trading and higher risk again.
Should a small company avoid these markets?
Not necessarily, though it should size the commitment so that a currency shock or payment delay cannot threaten the whole business.
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