Information about Asia and the Pacific Asia y el Pacífico
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Chapter 8. Frontier Markets in Asia and Beyond

Author(s):
Alfred Schipke
Published Date:
April 2015
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Nehad Chowdhury, Martin Edmonds and Chris Walker 

As growth in several major emerging market economies has slowed, economists and investors alike have shown more interest in a second group of countries in Asia and beyond—the frontier economies. A number of these economies have already accessed global capital markets, as noted in Chapter 1. A flurry of international bond issuances by some, and outsized gains in the equity markets of others, have boosted the prospects of frontier markets as an attractive investment destination. As a result, the question arises whether frontier markets will be in a position to capitalize on their recent successes and eventually graduate to emerging market status. Along the same lines, what are the lessons from today’s frontier markets for other fast-growing low-income countries, especially in Asia, as they try to become frontier markets?

With their strong growth prospects, relative underdevelopment, young and growing populations, and nascent financial markets, frontier economies present compelling investment opportunities (Figure 8.1). Strong returns in bond and equity markets, underpinned by domestic fundamentals and unusual external conditions, have resulted in increased investment portfolio allocations in frontier assets. A large number of lower-income countries, especially in Asia and Africa, have experienced prolonged growth spurts and significantly improved fundamentals, lending credibility to their claim to be considered frontier economies. As a group, frontier Asia has experienced growth over the past two decades averaging 6 percent, which only China and India have surpassed. Frontier economies have benefited from a supportive global environment of relatively low interest rates and high commodity prices. Many of these fast-growing low-income countries have been able to tap global capital markets and have also attracted investments from nonresidents in their domestic bond and equity markets. Even less-developed countries may join the club of frontier economies in the not-too-distant future.1

Figure 8.1Real GDP Growth

(Percent year-over-year)

Sources: IMF, World Economic Outlook database.

Note: CEE = Central and Eastern Europe; CIS = Commonwealth of Independent States.

This chapter explores the conditions under which such lower-income countries could advance to frontier or emerging market status. In many cases, this reflects not only the impact of improved fundamentals, but also the global liquidity environment. The analysis considers frontier economies from the capital market side, including both bond and equity markets. In the case of the former, it examines the ability of frontier economies to issue sovereign bonds (that is, external bonds), as well as the role of nonresident investments in local bond markets. The chapter also identifies the main elements that distinguish emerging markets from the more underdeveloped frontier markets and determines what is needed for frontier markets to become emerging markets.

What are Frontier Markets?

There is no uniform definition of frontier markets, but rather a common understanding that they do not fulfill the generalized criteria for full-fledged emerging markets. Following the advent of the concept of emerging markets in the early 1980s, Farida Khambata of the International Finance Corporation introduced the notion of frontier markets in the following decade. Generally speaking, frontier markets are smaller, less liquid, and less investable than their more established emerging market peers. Although “emerging market” has become a mainstream term, “frontier market” is still largely confined to the international investment community.

Frontier markets are occasionally grouped with other developing economies to differentiate them from developed economies, and they are considered a subset of the emerging market universe. More correctly, frontier markets should be viewed as a “preemerging market” class of markets. Apart from the International Finance Corporation, the international development community has not embraced the term. Frontier economies generally fall into subcategory (1) in Table 8.1’s classification in the subcategories of developing economies, but such groupings also include many countries that have no financial markets. Accordingly, this sweeping categorization does not accurately reflect the circumstances of frontier economies. Instead, families of bond and equity market indices as developed by the international investment community effectively remain the prime determinants of frontier market status.

Table 8.1Supranational Country Classifications
IMFUNDPWorld Bank
Name of “developed countries”Advanced countriesDeveloped countriesHigh-income countries
Name of “developing countries”Emerging and developing countriesDeveloping countriesLow- and middle-income countries
Development thresholdNot explicit75 percent in the Human Development Index distributionUS$6,000 GNI/capita in 1987 prices
Type of development thresholdMost likely absoluteRelativeAbsolute
Subcategories of “developing countries”(1) Low-income developing countries; and (2) Emerging and other developing countries(1) Low human development countries; (2) Medium human development countries; and (3) High human development countries(1) Low-income countries; and (2) Middle-income countries
Sources: Nielsen (2011); and IMF staff.Notes: GNI = gross national income; UNDP = United Nations Development Programme.
Sources: Nielsen (2011); and IMF staff.Notes: GNI = gross national income; UNDP = United Nations Development Programme.

The Frontier Bond Market Universe

To bond investors, frontier markets are most readily characterized by their credit ratings. As a general rule, sovereign ratings in such markets are below investment grade (BB+ or below on the Standard & Poor’s scale), although there are exceptions. Such ratings, in turn, reflect a number of conditions, including the sovereign’s issuance and debt service history, debt levels, macroeconomic and policy fundamentals, and political conditions that may affect either the willingness or ability to repay creditors. Many frontier markets have accessed global capital markets recently, and many have increasingly allowed investments by nonresidents in local bond markets.

Frontier market designations are largely the domain of index families established by the international investment community. Several major banks produce indices of emerging and frontier markets, including Bank of America Merrill Lynch, Barclays, Citigroup, and HSBC—but J.P. Morgan’s are the most popular benchmarks (Table 8.2; Kim 2014). Three such indices are the

  • EMBI (Emerging Markets Bond Index): The original EMBI index consisted of Brady bonds and as such was dominated by Latin American names. The ensuing EMBI+ added dollar-denominated loans and Eurobonds. The EMBI Global was added in 1999 with a far larger country set and further expanded coverage to quasisovereigns. By 2014, the EMBI Global had more than 50 countries represented. A variant, the EMBI Global Diversified index (which restricts constituent country weights to a maximum of 10 percent) is the mostly widely used benchmark for U.S. sovereign investors. There is further a U.S. dollar corporate equivalent (Corporate Emerging Markets Bond Index) as well as a Euro EMBI Global index.
  • NEXGEM (Next Generation Emerging Market): NEXGEM is a dollar index and is effectively a frontier market subset of the EMBI Global index. More than 80 percent of the index is rated single-B or lower. Asia accounts for 27 percent of the index (Figure 8.2). The external debt of Sri Lanka and Vietnam are in both the EMBI Global and NEXGEM indices. If Bangladesh were to issue a U.S. dollar–denominated bond of benchmark size it would very likely be included in these indices.
  • GBI (Government Bond Index): This index was launched in 1989 as a benchmark for global investors in developed government bond markets. The GBI Global comprises 13 countries with noticeable market depth and liquidity (Figure 8.3). The GBI Broad launched in 1997 expanded coverage as a response to investors looking for higher yields. The GBI-EM series was launched in 2005 to track performance in local emerging markets and has a fairly narrow focus. The GBI-EM Broad includes markets that may have impediments to investors, while the GBI-EM Global falls somewhere in between. The GBI-EM and GBI-EM Global both exclude China and India. The GBI-EM Global Diversified index is the most popular with investors.
Table 8.2Emerging and Frontier Bond Market Indices, End-2013
EMBI GlobalGBI-EMNEXGEMEMBI GlobalGBI-EMNEXGEM
ArmeniaLebanon
AngolaLithuania
ArgentinaMalaysia
AzerbaijanMexico
BelarusMongolia
BelizeMorocco
BoliviaMozambique
BrazilNamibia
BulgariaNigeria
ChilePakistan
ChinaPanama
ColombiaParaguay
Costa RicaPeru
Côte d’IvoirePhilippines
CroatiaPoland
Dominican RepublicRomania
EcuadorRussia
EgyptSenegal
El SalvadorSerbia
GabonSlovakia
GeorgiaSouth Africa
GhanaSri Lanka
GuatemalaTanzania
HondurasThailand
HungaryTrinidad and Tobago
IndiaTurkey
IndonesiaUkraine
IraqUruguay
JamaicaVenezuela
JordanVietnam
KazakhstanZambia
Latvia
Source: J.P. Morgan.Note: EMBI = Emerging Markets Bond Index; GBI-EM = Government Bond Index–Emerging Markets; NEXGEM = Next Generation Emerging Markets Index.
Source: J.P. Morgan.Note: EMBI = Emerging Markets Bond Index; GBI-EM = Government Bond Index–Emerging Markets; NEXGEM = Next Generation Emerging Markets Index.

Figure 8.2Next Generation Emerging Markets Index Composition

(Percent)

Source: Kim (2014).

Figure 8.3Government Bond Index–Emerging Market (GBI-EM) Index Composition

(Percent)

Source: Kim (2014).

No index exists for local currency sovereign bonds in frontier markets, reflecting the infancy of these markets. It is reasonable to think of the local currency bond market of each NEXGEM member as a frontier market in the context of local currency bonds. There are also countries whose dollar bonds are not seen as frontier markets and are not members of the NEXGEM index (such as Ukraine and Serbia) because they are too developed, but whose local currency debt would be considered a frontier market by investors. In Asia, the local bond markets in Indonesia, Malaysia, and the Philippines are part of the EMBI and GBI-EM index families.

The Frontier Equity Market Universe

The International Finance Corporation created the first frontier markets equity index, and later sold it (along with the attendant database including both frontier and emerging market components) to Standard & Poor’s, which recast it under its standard. There are currently four widely accepted frontier market index families: FTSE, Morgan Stanley Capital International (MSCI), Russell, and Standard & Poor’s (Table 8.3). MSCI is a leading benchmark, largely because its frontier markets index dovetails with its developed and emerging market indices. MSCI indices provide useful performance benchmarks for global equity market managers given their standard methodologies concerning constituents and valuations.2 Inclusion in a global market index is considered something of a milestone for national equity markets, as it gives them greater international exposure and targets their inclusion in index funds.

Table 8.3Frontier Equity Market Indices, End-2013 or Latest Available
FTSEMSCIRussellS&PFTSEMSCIRussellS&P
ArgentinaMalta
BahrainMorocco
BangladeshMauritius
BotswanaNamibia
BulgariaNigeria
ColombiaOman
Côte d’IvoirePakistan
CroatiaPanama
CyprusPapua New Guinea
EcuadorQatar
EstoniaRomania
GabonSerbia
GhanaSlovakia
JamaicaSlovenia
JordanSri Lanka
KazakhstanTrinidad and Tobago
KenyaTunisia
KuwaitUkraine
LebanonUnited Arab Emirates
LithuaniaVietnam
MacedoniaZambia
Source: Index web pages.Notes: FTSE = Financial Times and London Stock Exchange; MSCI = Morgan Stanley Capital International; S&P = Standard & Poor’s.
Source: Index web pages.Notes: FTSE = Financial Times and London Stock Exchange; MSCI = Morgan Stanley Capital International; S&P = Standard & Poor’s.

As with emerging markets, there is no standard metric to determine the constituents of frontier market indices, with each major firm establishing its own criteria. Financials are very prevalent in frontier markets (Figure 8.4), but commodity exposure is noticeably lacking due to the prevalence of international firms and sovereign restrictions. The four major firms tracking frontier markets share about 20 sovereign names, but beyond that the composition varies considerably. Each firm establishes its own determinants, considering aspects such as market capitalization, trading activity, investment restrictions, and trading infrastructure. These firms hold periodic reviews to determine whether a country should be included or excluded—or moved into another index group (either promoting or demoting its status).

Figure 8.4Frontier Equity Market Index Composition

(Percent)

Source: Buchanan (2012).

Notes: FTSE = Financial Times and London Stock Exchange; MSCI = Morgan Stanley Capital International; S&P = Standard & Poor’s; UAE = United Arab Emirates.

Frontier markets are decidedly heterogeneous, but they generally fall into three broad groupings:

  • Relatively advanced countries with very small markets (Estonia, Mauritius);
  • Countries with significant investment restrictions (Argentina; Gulf Cooperation Council, GCC, countries);
  • Countries with a relatively low level of development (Bangladesh, Ghana).

The inclusion of markets in GCC member countries in frontier indices may seem somewhat anomalous given their high incomes, but they are prominent (and somewhat predominant given their relative market size) in all four major index groups, given their investment restrictions.

Frontier Market Country Profiles

What are the common characteristics of frontier markets? Table 8.4 provides a snapshot and useful comparators with emerging and developed markets. Canvassing a broad set of indicators on macro factors, equities, risk, and exposures, frontier markets represent a wide range of general development and show some obvious areas of investor concern (Figure 8.5).

Table 8.4Selected Macroeconomic, Equity, Risk, and Exposure Indicators
Country/GroupMacroEquitiesRiskExposures
GDPGDP per CapitaCurrent Account BalanceGross General Govt DebtReservesMarket CapitalizatioStock Turnover/Market CapP/E ratioCredit RatingCorruption IndexPolitical Risk IndexPortfolio Flows/Market capEuropean Loans/TotalCommodities Exports/TotalEuro area Exports/Total ExportsChina Exports/Total Exports
($bn)($)(%of GDP)(96 of GDP)($bn)(96 of GDP)(96)(avg)(avg)(rank)(rank)(96)(96)(96)(96)(96)
2013201320132013201320132011201320132013201420132013201220132013
Argentina48811,766−0.946.928.310.04.85.5CCC+10671−4.983.430.19.77.1
Bahrain3227,43512.043.95.452.01.515.5BBB57689.085.883.73.00.8
Bangladesh1419041.837.017.624.192.612.9BB-1361230.687.76.333.11.7
Bulgaria537,3282.117.618.410.13.45.1BBB7761−6.298.525.745.12.7
Cambodia161,016−8.628.14.51404395.22.422.925.1
Croatia5813,5621.259.817.835.94.112.9BB+573911.498.316.750.80.6
Estonia2419,032−1.011.30.310.612.611.9A+2871−5.899.918.431.50.8
Jordan345,174−11.187.712.073.513.914.1BB-66580.580.221.32.21.5
Kazakhstan22012,8430.113.519.47.12.18.6BBB+140107−38.061.677.136.622.7
Kenya451,016−8.350.46.649.87.113.5B+13650−0.174.759.313.30.8
Kuwait18547,63938.85.332.355.519.416.9AA69115−15.460.195.85.28.8
Lao P.D.R.101,477−29.560.30.6833244.15.690.0
Lebanon449,920−16.2139.737.219.14.58.7B1274.171.55.67.61.0
Lithuania4816,0030.839.37.98.45.013.0BBB+4365−48.698.532.428.20.4
Mauritius129,160−9.153.83.380.98.09.7BBB+521350.580.22.239.20.6
Mongolia123,972−27.942.72.18.73.4BBB-15712074.993.82.024.5
Morocco1053,199−7.461.918.452.49.812.0BBB-91350.496.727.555.91.5
Myanmar56869^1.963.17.11273598.780.91.611.0
Nigeria2861,6924.719.41.228.69.212.2BB-1446511.771.592.228.71.5
Oman8125,2899.77.016.030.412.910.6A+61880.184.085.61.738.2
Pakistan2391,308−1.063.15.324.628.69.3B-127430.089.57.614.511.0
Qatar203100,26029.234.741.675.318.612.3AA28103−3.870.792.65.76.2
Romania1908,910−1.139.345.011.612.011.2BBB-697823.397.310.052.11.0
Serbia435,907−5.065.814.821.83.73.4BB-727628.399.19.243.30.1
Slovenia4722,7566.573.00.815.16.519.1BBB432274.298.14.652.50.7
Sri Lanka663,162−4.177.76.726.925.115.1B+91781.579.89.016.31.6
Tunisia474,345−8.444.47.316.911.016.0BB+7761−0.196.127.560.61.0
Ukraine1783,919−9.241.018.88.514.13.1AA262457.595.322.113.64.3
UAE39643,87614.912.368.247.515.912.6B-14427−16.775.738.83.24.4
Vietnam1711,9026.655.025.326.829.515.6B+116884.456.921.615.511.8
Frontier3,43615,7041.846.218.331.714.512.1BBB-84713.488.035.525.75.1
Frontier x-GCC2,6808,173−2.651.214.924.314.611.1BB92755.592.524.828.33.5
Frontier Asia7101,826−8.458.68.622.221.713.2B+12699−1.772.531.713.921.2
Emerging23,62811,025−0.449.3327.364.666.912.2BBB75632.769.528.220.410.8
Developed42,88148,8762.983.5142.4141.999.117.3AA2019−1.570.916.631.58.4
Sources: Bank for International Settlements; Bloomberg, L.P.; IMF, Direction of Trade Statistics database, International Financial Statistics database, and World Economic Outlook database; national authorities; PRS Group; Transparency.org; World Bank, World Integrated Trade Solution database; and IMF staff estimates.Note: Groups conform to MSCI index classifications as of the end of December 2013. Frontier Asia includes Bangladesh, Cambodia, Lao P.D.R., Mongolia, Myanmar, Sri Lanka, and Vietnam. GCC = Gulf Cooperation Council; P/E = price-to-earnings ratio; UAE = United Arab Emirates.
Sources: Bank for International Settlements; Bloomberg, L.P.; IMF, Direction of Trade Statistics database, International Financial Statistics database, and World Economic Outlook database; national authorities; PRS Group; Transparency.org; World Bank, World Integrated Trade Solution database; and IMF staff estimates.Note: Groups conform to MSCI index classifications as of the end of December 2013. Frontier Asia includes Bangladesh, Cambodia, Lao P.D.R., Mongolia, Myanmar, Sri Lanka, and Vietnam. GCC = Gulf Cooperation Council; P/E = price-to-earnings ratio; UAE = United Arab Emirates.

Figure 8.5Selected Indicators

Sources: Bank for International Settlements; Bloomberg, L.P.; IMF, World Economic Outlook database; and IMF staff estimates.

Note: DM = developed markets; EM = emerging markets; FA = frontier Asia; FM = frontier markets; GCC = Gulf Cooperation Council.

Frontier Equity Market Indices, End-2013 or Latest Available

Economy

The economies included in the frontier market universe range in size from a GDP of $12 billion for Mauritius to $488 billion for Argentina. But the $3.4 trillion total for the group is dwarfed by the $23.6 trillion for emerging markets and $42.9 trillion for developed markets. Per capita incomes in frontier markets range from about $1,000 a year (Bangladesh, Kenya) to more than $100,000 (Qatar). Excluding GCC countries, frontier markets rank below emerging markets on this score. The GCC factor is also significant when it comes to the current account. Excluding GCC members (which have current account surpluses in double digits largely due to high oil exports), frontier markets have an average current account balance of +1.8 percent of GDP, but only −2.6 excluding the GCC, compared with −0.4 percent for emerging markets and +2.9 percent for developed ones. The frontier debt profile is relatively sanguine and was on a downward trajectory up to 2008, but has been trending higher since then. Still, at 46.2 percent of GDP on average, it is comparable to emerging markets and substantially lower than the 83.5 percent of developed markets. So frontier markets are noticeably low on all measures.

Equity

Frontier market assets constitute a smallish 1–2 percent of equity assets globally. Market capitalization measured as a percent of GDP is a good proxy for financial sector development and provides a telling reminder that frontier markets are far below the development stage of emerging and developed markets. In 2013, frontier market capitalization was just 32 percent of GDP, compared with 65 percent for emerging markets and 142 percent for developed ones. Liquidity is also a big issue for frontier markets. Turnover as a percent of market capitalization is in the single digits in a large number of frontier markets, with the average of 15 percent far less than for emerging markets (67 percent) or developed markets (99 percent). Equity valuations in reporting frontier Asia markets are broadly in line with those of emerging markets.

Bond Markets

Asia’s frontier bond markets are much smaller and have sovereign credit ratings that are significantly lower than Asia’s emerging bond markets. Figure 8.6 shows the size and credit ratings of local currency bond markets in several Asian countries. The frontier markets are characterized by single- or double-B ratings, consistent with frontier markets globally. Asia’s emerging bond markets tend to have investment grade ratings. As a share of GDP, Asia’s frontier bond markets are generally larger than Africa’s, but are notably smaller than Asia’s emerging markets (Figure 8.7).

Figure 8.6Nominal Size and Credit Quality of Asia’s Frontier and Emerging Markets

(Billions of U.S. dollars)

Source: Asian Development Bank; national authorities; and IMF staff estimates.

Notes: Data are for end-2013 or latest available. S&P = Standard and Poor’s; Moody’s = Moody’s Investors Service.

Figure 8.7Comparison of Global Frontier and Emerging Local Currency Bond Markets

(Percent of GDP)

Sources: Asian Development Bank; national authorities; and IMF staff estimates. Note: Data are for end-2013 or latest available.

Frontier Market Performance

Frontier markets proved surprisingly resilient in 2013, a year in which many emerging markets struggled. Both bond and equity markets outperformed their emerging market counterparts. Frontier equities gained 5.5 percent in the first quarter of 2014, while emerging equities fell 0.8 percent. The outperformance partly reflects the illiquidity of frontier markets, which seems to provide a buffer during periods of sharply diminished risk appetite in global markets. It further reflects off-benchmark investments in these markets and the fact that hedge funds and other investors (especially in equities) follow a different dynamic when investing in frontiers than they do in the more traditional emerging market universe.

The historical record paints a more mixed picture. During the past few years, the risk-return profile of frontier market debt has largely bested that of emerging market debt. This has not been the case on the equity side, where emerging market metrics were generally better (Figure 8.8).

Figure 8.8Risk-Return Profiles

Sources: Bank of America Merrill Lynch; Bloomberg, L.P.; J.P. Morgan; Morgan Stanley Capital International; and IMF staff estimates.

Notes: DM = developed markets; EM = emerging markets; FM = frontier markets; U.S. = United States..

International bond issuance has soared. Many frontier economies came to market, and many were oversubscribed. In 2012, international bond issuance reached record amounts, totaling nearly $40 billion. First-time issuers typically access markets at spreads notably wide of the Emerging Markets Global Bond Index. The higher spreads reflect their weaker credit profiles, poorer secondary market liquidity, poorer transparency, and lack of a capital market financing track record. By contrast internationally, equity issuance has fallen off precipitously since the collapse of Lehman Brothers (Figure 8.9).

Figure 8.9International Bond and Equity Issuance

Source: Dealogic.

Notes: EMEA = Europe, Middle East, and Africa; GCC = Gulf Cooperation Council.

Investor Base

The potential investor base for frontier bond markets has shifted in recent years as low interest rates have pushed money across borders in a global search for yield. Buyers of global investment grade credit have crossed over (and are therefore referred to as crossover investors) to purchase investment grade and relatively liquid emerging market debt (of Brazil, Mexico, and Russia, among others—Figure 8.10), with some even venturing further into frontier markets.

Figure 8.10Investor Base by Region and Type

(Percent)

Sources: IMF, Global Financial Stability Report (October 2013).

Note: Weighted average for deals by Bolivia, Guatemala, Honduras, Mongolia, Nigeria, Paraguay, and Zambia.

Frontier equity markets represent a more challenging investment environment when compared with the global bond market for emerging market sovereigns. The simple and direct method of buying and selling common stocks in the local market can be problematic for investors, particularly retail ones.3 Foreigners may not be allowed to invest directly in some sectors or may be restricted from certain types of investments (especially in banking and strategic industries) or classes of shares. Often there are logistic problems associated with investing in multiple markets, each with its own custodial, financial, and legal system. Depository receipts (either global depository receipts or American depository receipts) represent an alternative avenue to gain exposure to frontier markets. Although there is a wide selection of American and global depository receipts of emerging market countries, the same does not hold for frontier issues.

Mutual funds are a popular channel for investing in frontier markets. A big draw is convenience, as the funds have done the groundwork for investing in different types of global markets, but management fees for frontier markets are relatively high. Emerging Portfolio Research tracks over 80 frontier market funds, but their assets are only about $10 billion, compared with about $700 billion for emerging market funds. Exchange-traded funds (ETFs) provide another route. While ETFs—like mutual funds—offer investors an interest in a pool of securities, they represent indices and are passively managed, so ETF redemptions do not trigger tax events as they do for mutual funds. The first frontier market ETF began trading on the London Stock Exchange in early 2008 and has since been joined by several others.

Hedge funds and private equity funds have a history of investment in frontier markets and have made major off-benchmark investments. Since frontier markets are often small, remote, and illiquid, they are not on the radar of most investment banks and analysts. Consequently, niche players such as hedge funds have capitalized on these factors and developed local expertise in these markets to seek out attractive investment opportunities. More recently, sovereign wealth funds, Asian family syndicates, and local market investors have ventured into frontier market investments. These investors are more resilient and less likely to shed their investments given the typical triggers that prompt selling by more traditional institutional investors. These new investors are more likely to be in the market for the long haul.

From Frontier to Emerging Market

What are the criteria for graduating from frontier to emerging market status? Given the high degree of heterogeneity among frontier markets, there is no single standard. Policy conditions include the stability of macroeconomic frameworks and the openness of capital and financial accounts. Achieving an investment grade sovereign rating, while neither a necessary nor a sufficient condition, can serve as a dividing line between the two classes of markets.

Prospects for continued capital market development in frontier Asia and other parts of the world are very good, given the growth outlook and positive demographics in many of these countries. But some major challenges need to be overcome. For bond markets, this is a matter of broadening market access to nonresident investors, thereby diversifying sources of funding and increasing depth and liquidity. This can take place via the issuance of domestic or hard currency bonds that nonresident investors are willing to purchase. In the case of hard currency bond markets, investors need to feel that the credit and liquidity risks are manageable. Aside from the credit ratings, this means that investors must be able to assess credit risks and that there is sufficient liquidity in the secondary markets to allow investors to exit if they wish.

When bonds are in local currency, investors also need to understand and manage the exchange rate risk. Most emerging local currency bond markets preferred by investors also tend to have floating exchange rates and a minimum of capital controls. Malaysia, Mexico, South Africa, and Thailand are examples of countries that investors see as established emerging markets for local currency bonds. So far, frontier countries such as Sri Lanka and Vietnam do not have the size or liquidity conditions that encourage nonresident investor participation, and this impedes their development.

Within Asia, Bangladesh, Sri Lanka, and Vietnam appear to be the most likely candidates to graduate from frontier to emerging status. Their local currency bond markets can be compared with Indonesia, Malaysia, Philippines, and Thailand—countries that have established themselves as relatively advanced among emerging markets. All are members of the GBI-EM index (for emerging market local currency debt) and none are in the NEXGEM index (for frontier market hard currency debt).

Conclusion and Implications for Policies

Well-regulated and developed markets can be an important catalyst for higher growth rates. Developed bond markets increase the reliability of fiscal financing by increasing both the size and diversity of funding sources, particularly as the share of nonresident investors rises. Greater and timelier disclosure of data and better regulations tend to encourage foreign participation in both bond and equity markets and can facilitate capital flows to the private sector with their own set of benefits (see Chapter 7 on addressing financial sector vulnerabilities).4 If accompanied by the appropriate institutional developments in the financial sector, a more developed domestic bond market can improve the transmission and effectiveness of monetary policy (see Chapter 9 on monetary policy frameworks). Collectively, these developments can reduce financing costs and improve growth profiles.

However, a rapidly growing domestic bond market with a high share of nonresident investors can also cause or exacerbate imbalances in the economy and lead to greater asset price volatility. Greater dependence on nonresident financing (particularly in the absence of sizable gross external assets) may make a country more vulnerable to a reversal of capital flows. Capital flows tend to be procyclical and may merit countercyclical measures during periods of inflows to mitigate the buildup of imbalances. A sharp, persistent reversal of capital flows poses myriad challenges to policymakers in the form of exchange rate volatility, inflation variability, and financial distress.5 Countries that have a larger change in the share of nonresident investors tend to experience greater volatility in the returns of domestic bonds. This is particularly true where the domestic investor base (pension funds, assets managers, banks) is not fully developed and the domestic market is characterized by low trading liquidity.6

Unconventional monetary policy in some advanced economies and low global interest rates have contributed to a global search for yield, which has benefited some frontier economies. An unwinding of these policies could adversely affect frontier markets. Changes in global risk perception could also have large impacts on frontier markets, with the risk of sudden stops. Countries with more open capital accounts and greater reliance on foreign capital flows could also experience capital outflows.

How then to increase the resilience of frontier markets? Continued improvement in economic fundamentals is one answer, accompanied by strengthening of policy buffers. In many frontier markets, policy frameworks remain relatively weak and have not kept up with the strong growth performance (financial sector regulation and supervision, corporate governance, transparency, provision of timely and reliable data, monetary policy frameworks, budget rules). Progress in these areas is needed not only to develop capital markets, but also to minimize vulnerabilities to shocks going forward.

References

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    International Monetary Fund (IMF). 2013b. World Economic Outlook.WashingtonOctober.

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    KimGloria.2014. J.P. Morgan Index Product Guide.New York: J.P. Morgan.

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1In the case of Asia, the investment community lacks consensus on which countries might join, but the frontier market cohort generally includes Pakistan, Sri Lanka, and Vietnam and sometimes Bangladesh and Mongolia. The next wave of frontier economies includes a group of smallish countries with financial markets at the early stages of development: Bhutan, Brunei Darussalam, Cambodia, Lao P.D.R., Maldives, Myanmar, Nepal, Papua New Guinea, and Timor-Leste.
2For this exercise, MSCI constituents are used for most data and analyses for equity frontier markets as well as for comparator indices for emerging and developed markets. This is convenient since MSCI is widely accepted as the global equity benchmark standard, employing a standard methodology across its equity universe.
3Investment restrictions can be found in the IMF Annual Report on Exchange Arrangements and Exchange Restrictions database. http://www.elibrary.imf.org/page/AREAER/www.imfareaer.org.
4These include the transfer of technology and skills from foreign companies in the case of foreign direct investment.
5The October 2013 World Economic Outlook discusses various characteristics that make some emerging markets more resilient than others to the volatility of capital flows.
6See the October 2012 Global Financial Stability Report for an analysis of the impact of nonresident investors and domestic market development on bond market volatility.

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