Being stuck deep in the frontier mode
Frontier markets have not been able to capitalise much from the boom times
Frontier markets are sometimes referred to as pre-emerging economies in the belief that they will one day graduate to full emerging market status. Anyone investing on this basis might want to rethink, however.
Given that most frontier market countries are significant commodity exporters, the commodity supercycle that ran for most of the past decade might appear to have been the perfect environment for the likes of Nigeria, Vietnam and Belarus.
But during the past decade, Moody’s, the credit rating agency, has seen fit to raise its rating for just one of the 29 frontier markets it covers, Bolivia. In contrast, 13 have a lower rating than Moody’s initially assigned to them, with Egypt, Ghana, Vietnam and Mongolia among those downgraded.
“While they remain popular avenues for equity and bond investors, none of the frontier market sovereigns have seen dramatic improvements in their credit profiles over the past 10 years,” Moody’s says.
“The scope of frontier markets as longterm investment plays will depend on whether, and how quickly, their riskreward profiles converge with those of emerging markets.”
Moody’s does proffer the caveat that many of these countries have short rating histories. Yet this cannot fully explain the negative trend; countries such as Fiji, Jordan, Honduras, Moldova and Pakistan, which were first rated in the 1990s, have gone backwards since then, in the rating agency’s eyes.
Rising debt burdens
Worse may be to come. Moody’s ascribes negative credit outlooks to seven of the 29 countries but a positive outlook to just Georgia, Honduras and Senegal.
One of its big concerns is rising debt burdens. Between 2000 and 2008, the median debt burden across the 29 tumbled from 76.2 per cent of gross domestic product to 31.3 per cent, primarily due to debt relief through the Highly Indebted Poor Countries Initiative.
However, according to Moody’s, it has since inched back up to 42.1 per cent of GDP, above the 39.8 per cent figure for emerging markets, with Egypt, Jordan and Sri Lanka among the most indebted.
If frontier market countries are not capable of moving upwards, even during a broadly supportive global environment, this has implications for investors, but more so for the 1.1 billion people, 15 per cent of the world’s population, who reside in them. In aggregate, they may account for just 3 per cent of global GDP, but their current low income levels, combined with young populations (with an average age of 25, compared with 37 in China), are commonly cited as reasons why they can outperform emerging and developed nations and transcend their frontier status.
As a group, they produced median GDP growth of 5.5 per cent a year between 2000 and 2014, outstripping the 4.2 per cent recorded by emerging markets, thanks to robust commodity prices and an influx of foreign direct investment in extractive industries, according to Moody’s.
However, the quality of this growth was often poor. In each year between 2007 and 2014, total factor productivity across frontier markets declined, subtracting from overall growth, according to analysis by The Conference Board. Instead, GDP growth was merely driven by an increased supply of capital and labour.
Neil Shearing, chief emerging market economist at Capital Economics, believes this is a crucial factor.
While it may be relatively easy, in theory at least, for a country to ascend from poor to middle-income status if it adopts the correct policies, making further progress relies on raising total factor productivity growth, Shearing argues, rather than just calling up more capital and labour.
Achieving this is a “bit more difficult”, requiring upfront investment in skills and research and development.
Given this possibility, though, Shearing does not believe frontier market countries are “condemned in any way, shape or form”, to remain frontier. But he does believe any advance will be slow.
Failure to accumulate savings
Looking back at the progress seemingly made in the past 15 years by sub-Saharan commodity exporters, some of the poorest countries on the planet, Shearing says twothirds of the pick-up in growth can be explained by the commodity boom, “maybe three-quarters when you start to add in some of the indirect effects”.
A failure to accumulate savings in the boom years in countries such as oil-rich Nigeria made it harder still for many states to hold on to the temporary gains when the commodity cycle turned.
“Expectations were too high, rather than countries being doomed to always lag behind,” says Shearing.
“They are going to converge but they are going to be converging at a slower rate than was expected. The expectations are now starting to be adjusted but because their institutions are less developed, they are more prone to shocks.”
The failure so far of frontier nations to step up to full emerging status has parallels with the relatively few emerging countries that have become developed, despite this latter process having had far longer to work through.
Marc Chandler, global head of market strategy at Brown Brothers Harriman, argues such promotion has “proven difficult, though not impossible”, with Japan blazing a trail in the 1950s and 1960s when it adopted an export-oriented model and “succeeded in moving up the value chain quickly”.
Transitions difficult to replicate
However, he argues that the examples of the handful of other countries that have made the transition to developed status “are difficult to replicate”.
“Consider that many successful emerging market economies in Asia [such as Hong Kong and Singapore] were British colonies. Others, like South Korea and Taiwan, were aided by a superpower rivalry,” says Chandler.
Moreover, there is no universal acceptance that any of these latter countries are developed. MSCI, the index provider, for instance, still classifies them all as emerging.
Shearing agrees that the experience of small entities such as Hong Kong and Singapore probably does not produce many meaningful conclusions.
Nevertheless, he does think the journeys of South Korea and the Czech Republic, another country he believes is making the transition to developed status, are more replicable.
“There is a pattern there, they were manufacturing-based economies,” he says.
This ties in neatly with the failure of many frontier markets to make concerted progress. In the wake of EM Squared’s calling into question the “Africa rising” narrative that has dominated in recent years, much of the subsequent debate has centred on the continent’s lack of progress in building a manufacturing base.