Why Foreign Investors Invest in Emerging Markets

By

Tushar Shubhra Dasgupta

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Table of contents

Abstract……………………………………………………………....Page 3

1 Introduction……………………………………………………..........Page 3

2 Emerging Market…………….……………………………………….Page 3

2.1 Why Emerging Markets….……………………………..........Page 3

2.2 Challenges of Emerging Market...…………………………....Page 5

3 Benefits of Foreign Investors Investment in Emerging Market ….....Page 6

3.1 Risk Reduction………………………………………………..Page 7

3.2 Other Risk Reduction…………………………………...........Page 7

4 Invest in Emerging Markets like India & China……………………Page 8

4.1 Why to invest in India………………………………………...Page 8

4.2 Why to invest in China……………………………………….Page 10

5 Conclusion………………………………………………………..........Page 12

References

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Abstract

Emerging markets are rapidly becoming a preferred of international investors. These markets are

involved of countries that have, up until this point, been undeveloped. These countries may not

have the necessary infrastructure to be real economic powers. As populations increase, more of

these countries are starting to become developed. Investors can put money into these markets and

potentially make large returns on their investments. So many different industries and sectors are

growing in these markets that it can bring investors very large returns. [1] Choosing an emerging

market in which to invest requires a great deal of research. Investors are turning to emerging

markets as a way to increase returns on investment by diversifying their investment portfolio in

order to reduce risk on return and also to generate expertise, technology or some other benefits

for the company. This paper talks about why foreign investors invest in emerging markets,

especially growing diversified markets like India, and China.

1. Introduction

Emerging markets are countries that are restructuring their economies along market-oriented

lines and offer a wealth of opportunities in trade, technology transfers, and foreign direct

investment. [2] According to the World Bank, the five biggest emerging markets are China, India,

Indonesia, Brazil and Russia. Other countries that are also considered as emerging markets

include Mexico, Argentina, South Africa, Poland, Turkey, and South Korea. These countries

made a critical transition from a developing country to an emerging market. Each of them is

important as an individual market and the combined effect of the group as a whole will change

the face of global economics and politics. [3]

2. Emerging Market

2.1 Why emerging markets

Emerging markets stand out due to four major characteristics. First, they are regional economic

powerhouses with large populations, large resource bases, and large markets. Their economic

success will spur development in the countries around them; but if they experience an economic

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crisis, they can bring their neighbors down with them. Second, they are transitional societies that

are undertaking domestic economic and political reforms. They adopt open door policies to

replace their traditional state interventionist policies that failed to produce sustainable economic

growth. Third, they are the world's fastest growing economies, contributing to a great deal of the

world's explosive growth of trade. By 2020, the five biggest emerging markets' share of world

output will double to 16.1 percent from 7.8 percent in 1992. They will also become more

significant buyers of goods and services than industrialized countries. Fourth, they are critical

participants in the world's major political, economic, and social affairs. They are seeking a larger

voice in international politics and a bigger slice of the global economic pie. There are two

potential causes for the creation of emerging markets: the failure of state-led economic

development and the need for capital investment. First, state-led economic development failed to

produce sustainable growth in the traditional developing countries. This failure and its

tremendous negative impact pushed those countries to adopt open door policies, and to change

from the state's being in charge of the economy to facilitating economic growth along market-

oriented lines. Second, the developing counties desperately needed capital to finance their

development, but the traditional government borrowing failed to fuel the development process.

In the past, the governments of the developing countries borrowed either from commercial banks

or from foreign governments and multilateral lenders like the IMF and the Word Bank. This

often resulted in heavy debt overload and led to a severe economic imbalance. The past track

record of many developing countries also demonstrates their inability to well manage and

efficiently operate the borrowed funds to support economic growth. In light of the unsatisfactory

results of government borrowing, developing countries began to rely on equity investment as a

means of financing economic growth. They seek to attract equity investment from private

investors who will become their partners in development. To attract equity financing, a

developing country has to establish the preconditions of a market economy and create a business

climate that meets the expectations of foreign investors. This change in financing sources thus

became another factor leading to the rise of emerging markets. The rise of emerging markets is

changing the traditional view of development as follows. First, foreign investment is replacing

foreign assistance. Investing in the emerging markets is no longer associated with the traditional

notion of providing development assistance to poorer nations. Second, emerging markets are

rationalizing their trade relations and capital investment with industrialized countries. Trade and

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capital flows are directed more toward new market opportunities, and less by political

consideration. Third, the increasing two-way trade and capital flows between emerging markets

and industrialized countries reflect the transition from dependency to global interdependency.

The accelerated information exchange, especially with the aid of the Internet, is integrating

emerging markets into the global market at a faster pace.

2.2 Challenges of emerging market

In their effort to create a market economy and to ensure sustainable development, emerging

markets still face big challenges that come from fundamental problems associated with their

traditional economic and political systems. A market economy requires those countries to

redefine the role of the government in the development process and to reduce the government's

undue intervention. Another serious problem that those countries have to confront is controlling

corruption, which distorts the business environment and impedes the development process. An

even more challenging task for those countries is to undertake structural reforms with their

financial system, legal system, and political system, so as to guarantee a disciplined and stable

economy that is relatively free of political disturbances and interference. [4]

Emerging markets are the key swing facto in the future growth of world trade and global

financial stability, and they will become critical players in global politics. They have a huge

untapped potential and they are determined to undertake domestic reforms to support sustainable

economic growth. If they can maintain political stability and succeed with their structural

reforms, their future is promising.

3. Benefits of Foreign Investors Investment in Emerging Market

The rise and volatility of international capital flows has often been regarded as a major source of

financial crises in emerging markets. An important component of these flows has been portfolio

investment in the form of investment in equities and bonds. In most cases, investors behind these

portfolio flows to emerging markets are institutional investors, such as mutual or pension’s funds

and insurance companies. As a matter of act, institutional investors can be regarded as the

kingpins of financial globalization. At least for mature markets, their behavior has therefore been

intensely investigated. For emerging markets, however, it has only recently received more

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attention too. During the past few years, several empirical studies have been presented on the

developments and the determinants of international capital flows and on the behavior of

institutional investors in particular. Initially, these studies focused on the gains from

diversification into emerging markets. It seemed to be a matter of normal developments that

emerging markets become part of the global world-market portfolio. [5]

International portfolio diversification has long been advocated as an effective way to achieve

higher risk-adjusted returns than domestic investment alone. The main premise underlying this

strategy is that international stocks tend to display lower levels of co-movement than stocks

trading on the same market. To the extent that countries are subject to different shocks, then

international diversification facilitates risk sharing among global investors. Idiosyncratic shocks

may be diversified away. Thus investors who pursue cross-country diversification strategies may

eliminate country-specific risks but remain vulnerable to common shocks. Therefore the

realization and magnitude of portfolio diversification benefits depends crucially on the relative

size, frequency and persistence of idiosyncratic and common shocks. The benefits of foreign

investment accrue to a representative US investor who considers international investment

opportunities across the other G-7 countries. (6)

3.1 Risk reduction:

It is possible for multinational firms to reduce the risk of their profits by engaging in foreign

operations (F/T). Empirical tests show that the (F/T) variable is inversely related to risk after

allowing for size, industry classification, and other factors. This implies that international

investment through diversification offers to a multinational firm significant risk reduction

advantages that are not available to a non-multinational. [7] One variable, the ratio of foreign to

total activities (F/T) is worthy of consideration; and that firms with implications higher (F/T)

ratio are able to reduce the variance of their earnings, where variance is a proxy for risk. This

significance remains when other important variables, such as size and dummies for industry

classification, are specified as independent variables. There is a possible downward bias in the

result so wing to the selection of U.S. corporations for the analysis. The U.S. market is already

large and well diversified, especially on regional grounds. Although a foreign investment

variable is desirable when portfolio theory is used to determine the actions of individual asset

holders in an international context, a foreign operations variable is suitable when the activities of

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multinational firms are being analyzed. Foreign operations must be used instead of direct

investment because of data limitations; there are no published data on foreign investment of

firms-this information is available only at the industry level. [8]

A diversified portfolio has systematic risk and unsystematic risk. Systematic risk is the risk of

the market itself. Unsystematic risk is the risk of individual securities within the market and the

portfolio. Increasing the number of securities in the portfolio reduces and ultimately eliminates

the unsystematic risk—the risk of the individual securities—leaving only the risk of the market,

the systematic risk.

3.2 Other risk reduction:

Market risk: All market risk is not the same because all markets, like individual assets, are not

perfectly correlated in their returns. The addition of additional markets to the potential portfolio

of the investor reduces the overall market risk below that of any individual market.

Currency risk: Currency risk for a portfolio, like currency risk for a firm or a currency

speculator, can be positive or negative. If individual investor buys a security denominated in a

currency, which then appreciates against the home currency of the investor, it increases the

expected returns of the investor in home currency terms. Different international portfolios and

portfolio managers deal with this concern very differently. Some international portfolios wish to

hedge the currency risk as much as possible, focusing on the expected returns and risks of the

individual assets for their portfolio goals. Other managers, however, use the currency of

denomination of the asset as part of the expected returns and risks from which the manager is

trying to profit.

3.3 Minimum risk portfolio:

The portfolio with the lowest expected risk is not the same thing as the optimal portfolio. The

portfolio with minimum risk is measured only on that basis risk and does not consider the

relative amount of expected return per unit of expected risk. Modern portfolio theory assumes

that investors are risk averse, but are in search of the highest expected return per unit of risk

which they can achieve. [9]

Two methods have generally been used equity markets. The second method uses the regression

of returns of individual stocks or national market indices against a world market index. The

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interpretation, then, is that the variation of the stock's (index's) return which is not explained by

the world market index is diversifiable in the context of a world market portfolio.

Obviously, the diversifiable risk of a security could change considerably if different directories

were used. Finally, an accurate assessment of the net benefits of international investment

requires information on the pricing and extent of foreign goods in consumption, as well as the

degree of risk aversion of investors. Abstracting from these issues, a large number of studies

have identified diversification gains that have been available to (American) investors. However,

with the increase of economic interdependence among industrialized countries and the relaxation

of barriers to capital and goods movements, the potential benefits of international investment

diversification may not be as significant as indicated in the early studies. As the economies of

different countries are tied closer and closer together, securities markets tend to move in the

same direction, thus increasing the correlation between domestic and foreign securities and

reducing potential benefits from diversification. Nevertheless, given the growing integration of

world financial markets, the inter-correlation of capital markets is still surprisingly low. Looking

at international stock markets, correlations across countries are generally positive but low, with

little difference in results when returns are hedged against currency risk.

4. Invest in Emerging Markets like India & China

4.1 Why to invest in India

Foreign institutional investors have gained a significant role in Indian capital markets.

Availability of foreign capital depends on many firm specific factors other than economic

development of the country. It is observed that foreign investors invested more in companies

with a higher volume of shares owned by the general public. The promoters’ holdings and the

foreign investments are inversely related. Foreign investors choose the companies where family

shareholding of promoters is not substantial. Among the financial performance variables the

share returns and earnings per share are significant factors influencing their investment decision.

Countries and firms are interested in attracting foreign capital because it helps to create liquidity

for both the firms stock and the stock market in general. This leads to lower cost of capital for

the firm and allows firm to compete more effectively in the global market place. This directly

benefits the economy and the country. Availability of foreign capital depends on many firm

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specific factors other than economic development of the country. The Indian stock market is

booming. Having fallen along with other world markets during last year’s crash, it actually

bucked the global trend and was nowhere near testing its multi-year lows. India’s stock market

returns over the past couple of years have actually beaten most other global markets. Firs reason,

while it’s still classed as an emerging market, India’s strength comes from the fact that its

internal market is not only huge, but also better insulated than China, Brazil, Russia and South

Korea. It operates at its own pace, seemingly oblivious to what happens around it. Second, with a

population of over one billion, India has a huge edge over smaller emerging markets because it

has the critical mass to withstand minor shocks to the system. Third, India isn’t reliant on a huge

export market for the bulk of its growth. Fourth, it has a huge, educated middle class. In fact,

India’s middle class population is larger than that of the entire United States. Of course, this

middle class earns less on average than poverty line families in America, but it has the capacity

to spend enough money to buy products that were once considered luxuries. This generates

tremendous economic activity without the issues of trade balance. Fifth, India’s protectionist

business nature, companies tend to thrive without the threat of multi-national competition.

Best ways to invest in India is to buy shares of an exchange-traded fund (ETF) such as the Power

Shares India or Wisdom Tree India Earnings or another way is to buy individual Indian

companies. However, they’re quite impenetrable. Even, infrastructure Boom Spells Profits for

India’s Construction Giants. Along with a growing export market, India is also in the midst of a

multi-hundred billion-dollar infrastructure boom. The investment potential within the

infrastructure sector is enormous. Companies like Larson & Toubro dominate the construction

and infrastructure markets and are very well positioned to profit from the increased spending.

And while there are obviously a huge number of foreign companies that operate in India, they

have to deal with the unpredictability of a market that is open, yet closed. For Indian firms,

however, the sky is the limit. The home-grown successes of Tata Motors, Reliance Capital and

Mittal, before it became international steel giant, Arcelor-Mittal have allowed them to build up

huge war chests of cash. They’re now re-deploying it into the relatively young Indian export

market. Investment U’s own parent company has business operations in India and the division

has become one of the most respected and fastest-growing financial research firms in the

country. [10] The Indian economy is definitely prospective over decades of its history and shows

further rejuvenating investments at the end of each fiscal year. With the emergence of new

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sectors like Telecom, medicine, metals, IT and outsourcing, the stock market has gained strong

feet into the global scenario. With potential investment options, the Indian market economy

shows an improved and a quicker recovery time than the European and the US market. Foreign

investment additionally supports the economy, showing belief in the recovery trends of the

Indian market. All stock exchanges remain inherent with its feature of volatility; however the

Indian stock market has always proved itself by showing expansion. Befitting the growth trends,

the SEBI regulations further enhance investments that support the sector specific industries as

well as attract foreign investments by setting investor-friendly norms for them. With the advent

of online stock trading, the intricacies of the functioning of the market strategies have now been

known; thus bringing to fore the complicated, hidden investment stratagem. Good broker portals

now adorn the strong functioning of the market. [11] India has experienced an increase in portfolio

inflows thanks to investors in sluggish developed markets seeking higher returns in the robust

Asia markets, Reuters reported. With most developed markets experiencing a slowed recovery,

with underperforming markets; the Indian and Asian markets at large have shown impressive

buoyancy and a potential for higher returns. Foreign investors are given limited permissions over

purchases and access to the securities markets. The regulations require that all spot deals against

the Indian currency be settled onshore. The onshore forward market can be used to hedge

commercial transactions by foreign companies operating in India. Investors can bet on the

currency offshore through non-deliverable forwards and interest rate swaps. The only overseas

investors permitted to buy Indian government and corporate debts are non-resident Indians and

registered FIIs. Total FII investment is limited to a ceiling of USD 10 billion in government debt

and USD 20 billion in corporate debt. Both ceilings were raised by USD 5 billion on Sept. 23.

Foreign investors have to pay a 20% withholding tax on interest income, unless tax treaties with

other countries say otherwise. Many foreign investors, particularly hedge funds, invest in India

via offshore derivatives, rather than register as FIIs. The SEBI has strict disclosure mechanisms

for institutions issuing these products, requiring them to provide details of the ultimate

beneficiary client. [12]

4.2 Why to invest in China

The foreign investments are basically divided into direct investment and other means of

investment. The direct investment, which is widely adopted, includes Sino-foreign joint ventures,

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joint exploitation and exclusively foreign-owned enterprises, foreign-funded share-holding

companies and joint development. The other means of investment includes compensation trade

and processing and assembling. Sino-foreign joint ventures are also known as share-holding

corporations. They are formed in China with joint capitals by foreign companies, enterprises,

other economic organizations and individuals with Chinese companies, enterprises, other

economic organizations and individuals. The main feature is that the joint parties invest together,

operate together, take risk according to the ratio of their capitals and take responsibility of losses

and profits. The capitals from different parties are translated into the ratios of capitals, and in

general the capital from foreign party should not be lower than 25%. The Sino-foreign joint

ventures are among the first forms of China's absorption of foreign direct investment and they

account for the biggest part. At present they are still a great part in the absorption of foreign

investments. Cooperative businesses are formed in China with joint capitals or terms of

cooperation by foreign companies, enterprises, other economic organizations and individuals

with Chinese companies, enterprises, other economic organizations and individuals. The rights

and obligations of different parties are embedded in the contract. To establish a cooperative

business, the foreign party, generally speaking, supplies all or most of the capital while Chinese

party supplies land, factory buildings, and useful facilities, and also some supply a certain

amount of capital, too. Foreign-funded share-holding company’s foreign companies, enterprises,

other economic organizations and individuals can form foreign funded share-holding companies

in China with Chinese companies, enterprises, and other economic organizations. The total

capital of the share-holding company is formed by equal shares, shareholders will take due

responsibilities for the company according to shares purchased; company will take

responsibilities for all its debts through all its assets and the Chinese and foreign shareholders

will hold the shares of the company. Among them, the shares purchased and held by foreign

investors account for more than 25% of the total registered capital of the company. Limited

company can be founded either by means of starting-up or rising, and the limited liability

company invested by the foreigners can also apply to turn into share-holding companies. New

types of foreign investment While expanding areas and opening-up domestic market, China is

also exploring and expanding actively its new types of utilizing foreign investment such as BOT,

investment company and so on. Since multinational merger and acquisition has become the

major type of international direct investment, Chinese government is now researching and

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enacting related policies so as to facilitate the foreigners to invest in China by means of merger

and acquisition. Joint exploitation is the abbreviation of maritime and overland oil joint

exploitation. It is a widely adopted measure of economic cooperation in the international natural

resources field. The striking features are high risk, high investment and high reward. The joint

development is often divided into three steps: exploitation, development and production.

Compared with the other three means mentioned above, joint cooperation accounts for a small

ratio. Exclusively foreign-owned enterprises, which are totally invested by foreign party in China

by foreign companies, enterprises, other economic organizations and individuals in accordance

with laws of China. According to the law of foreign-funded enterprises, the establishment of

foreign enterprises should benefit the development of our national economy and agree with at

least one of the following criteria: the enterprises must adopt international advanced technology

and facility; all or most of the products must be export-oriented. The foreign funded enterprises

often take the form of limited liability. [13]

5. Conclusion

Emerging market is an increase in both local and foreign investment portfolio and direct

investment portfolio. A growth in speculation in a country frequently indicates that the country

has been able to build poise in the local economy. An emerging market economy must have to

weigh local political and social factors as it attempts to open up its economy to the world. [14]

Moreover, foreign investment is a signal that the world has begun to take notice of the emerging

market, and when international capital flows are directed toward an EME, the injection of

foreign currency into the local economy adds volume to the country's stock market and long-

term investment to the infrastructure. Although emerging economies may be able to look forward

to brighter opportunities and offer new areas of investment for foreign and developed economies,

local officials in EMEs need to consider the effects of an open economy on citizens.

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Reference

1. http://www.ehow.com/about_7378614_foreign-direct-investment-emerging-

markets.html#ixzz15qPx5QRP

2. http://www.aima-ind.org/ejournal/ManagingEditor.asp

3. http://lagodaxnian.wordpress.com/2010/03/11/who-are-the-big-emerging-markets-and-why-

are-they-important/

4. http://www.uiowa.edu/ifdebook/faq/faq_docs/emerging_markets.shtml

5. Bekaert, Geert (1995), Market Integration and Investment Barriers in Emerging Equity

Markets, World Bank Economic Review, 9, 75-107.

6. http://www.tcd.ie/iiis/documents/discussion/pdfs/iiisdp167.pdf

7. The Advantages of International Portfolio Diversification | eHow.com

http://www.ehow.com/list_7201697_advantages-international-portfolio-

diversification.html#ixzz15NMTA1vg

8. http://www.palgrave-journals.com/jibs/journal/v7/n2/pdf/8490702a.pdf

9. www.franke.nau.edu/faculty/download_process.asp?id=5273

10. Why the Indian Stock Market is Booming – And How You Can Take Advantage

by Karim Rahemtulla, Emerging Markets Analyst Tuesday, April 6, 2010: Issue #1232

11. http://www.investmentu.com/2010/April/why-the-indian-stock-market-is-

booming.html#comment-65663

12. http://www.investinindia.com/news/india-experiences-increase-foreign-portfolio-inflows-

investors-seek-higher-returns-robust-asia-25g6

13. http://investchina.sina.com/display_why_invest.php?w_id=6&en_f=en

14. http://www.investopedia.com/articles/03/073003.asp

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