Frontier markets offer investors new opportunities. But what about the risks?
Globalization has connected the world over the last two decades and offered investors access to a growing set of investment opportunities and capital markets, particularly in emerging markets. Strong capital inflows, improved liquidity conditions and higher research coverage have since helped mature these once unconventional markets. Those interested in novel investment opportunities have in turn started to move toward investing in frontier economies.
The term frontier market was coined in 1992 by the International Finance Corporation, a subsidiary of the World Bank group that focuses on private-sector development in less developed countries. The term describes investable developing countries that are often smaller, less developed or less accessible than countries generally classified as emerging markets.
In general, the lines between advanced, emerging, frontier and other developing nations are blurry, and different organizations and index providers use slightly different definitions. In consequence, finding unifying criteria to subsume these close to 140 heterogeneous economies is inherently difficult. More often than not, a frontier market is a rapidly growing and industrializing economy, with less developed capital markets and younger populations. In value-added terms, frontier economies are more heavily grounded in agriculture and manufacturing and it is not uncommon for some of these countries to have export structures that are geared toward commodities.
There are several compelling reasons for investors to consider frontier economies in their asset allocation process on an outright or complementary basis: A key premise of frontier and emerging market investing relates to the growth potential they offer, and indeed, frontier economies have been outgrowing developed markets by about 2 percentage points per annum over the last 20 years. According to forecasts of the International Monetary Fund (IMF), twenty-eight of the thirty fastest growing economies between 2022 and 2026 are considered frontier markets. Among them are many Sub-Saharan African economies as well as various Southeast Asian countries like Bangladesh, Vietnam or Cambodia.
In contrast to advanced economies, emerging markets in general, and frontier markets in particular, continue to enjoy a favorable demographic backdrop in the form of strong population, and more importantly, working-age population growth. Historically speaking, countries that successfully reap this demographic advantage tend to experience a two-to-three-decade boost to productivity.
Countries that successfully reap this demographic advantage tend to experience a two-to-three-decade boost.
The growing manufacturing and service sectors in frontier economies foster urbanization, as people leave employment in the rural low-wage agricultural sector for higher earning jobs in cities. Consequently, infrastructure, clusters of innovation, and economies of scale are created, boosting productivity in the process. According to the World Bank, about 80% of global GDP is generated in cities.
As the relationship between urbanization and growth tends to be non-linear (for example workforce training needs to keep up with growing infrastructure and public transportation), the highest productivity gains are associated with urbanization rates between 35% and 55%. No less than 45% of all frontier markets are currently in this urbanization sweet spot, and about 91% of all frontier economies remain at urbanization levels associated with positive contributions to productivity.
Efficiency gains in frontier economies are further accelerated by technological leapfrogging, that is the opportunity to skip expansive and less efficient legacy infrastructure like telephone landlines or ATM systems and jump directly to using wireless communications and mobile payments. Moreover, the ability to leapfrog also changes origin and direction of innovation flows, as certain innovations are introduced or commercialized in frontier and emerging economies first.
Social media, e-payments and e-commerce as well as digital health care or online education are just a few fields that come to mind. These dynamics are likely to strengthen as internet adoption increases. Today, almost 60% of the population in developing economies are connected to the internet. By comparison, less than 25% were in 2010.
Although growth in emerging and frontier economies is still strongly associated with commodities and/or manufacturing, the picture is more nuanced nowadays, especially in the larger developing economies. While the level of technological innovation like in China or India is not yet the norm in frontier economies, sustained increases in secondary and tertiary education over the past decade, combined with strong population growth, will continue to rapidly enlarge the talent pool and human capital in developing economies, improving and diversifying the drivers of growth concomitantly.
As mentioned, investing in frontier economies offers access to some of the world’s fastest growing economies, growing working-age populations and rapidly urbanizing societies. In addition, the frontier universe spans across 140 countries, and in turn, economic outcomes differ considerably, from some of the poorest nations like Zambia or Bangladesh to countries like Croatia or Serbia that are converging with developed market living standards on a variety of metrics.
The frontier market universe provides investors with greater natural diversification.
In consequence, frontier market returns tend to be relatively uncorrelated – not just with global capital markets but also within the frontier market universe. After all, the discovery of new oil and gas reserves off the coast of Guyana are unlikely to affect growth rates in export-oriented Vietnam. Likewise, a regime change in Peru bears little significance for the economic outlook of service-oriented Romania. As a result, the heterogeneity of the frontier market universe provides investors with greater natural diversification relative to developed and emerging economies and reduces contagion among frontier markets.
Another important driver of diversification is the structure of the market. In contrast to traditional local currency and hard currency bond markets, the foreign ownership is extremely low. Instead, the local financial system (pension funds, insurance companies, banks) in frontier markets serves as the “natural” buyer of government bonds denominated in the local currency. As a consequence and in case of exceptional high or low risk aversion among global investors, frontier markets are substantially less driven by massive inflows or outflows compared to other asset classes. As such, positive and negative outliers have not been observed in the asset class driven by “hot” and fast-moving money. As a result, correlation and volatilities have been low or lower.
Investing in frontier economies, and like with other asset classes, has its own specific risks. Many frontier countries are still in the early stages of their development path and there are clear identifiable vulnerabilities as local financial markets and institutional framework are still immature. However, during the last decade, frontier market policy makers have understood the importance of the transparency and clarity of both fiscal and monetary policy.
Governments and central banks have taken huge steps forward on both fronts and have upgraded the predictability of the fiscal and monetary policy framework by moving into budget planning and updating as well as inflation targeting. The consequence of these changes has also been evident during the recent global stress periods (for example the US presidential elections in the fall of 2016, tighter monetary conditions in 2018 and the Covid-19 crisis in 2020), when frontier market local currency debt performance has proved to be more defensive than traditional emerging market local and hard currency bonds.
The combination of diversification benefits within the universe, low correlation to other asset classes and increased fiscal and monetary prudence in many countries has resulted in very favorable absolute and relative risk-adjusted returns over time. Despite the risks that are associated with frontier markets as mentioned earlier, drawdown characteristics in crisis periods are exceptional and also a result of the three factors mentioned. Therefore, adding frontier market local currency debt to an investment portfolio has been very beneficial for investors and the performance pattern of the asset class has not been exotic at all.