Extreme markets are hot - but don't get burned

published 25 May 2007

First, cash poured into Brazil and Russia. Then it flooded into riskier destinations, such as Turkey. Now investors are venturing into even dodgier markets in their quest for high returns. Bond fund managers have delved into Iraqi debt; professional equity investors have been exploring the likes of Botswana and Ukraine, helping to drive these markets up by a respective 38% and 77% this year alone. The Standard & Poor's Frontier Index comprising 22 of the smallest and most illiquid emerging markets is up by 400% since 2002.

Mounting interest in Colombia is symptomatic of the trend. Over the past four years, President Alvaro Uribe's "iron-fisted" clampdown on guerillas has restored confidence after five decades of civil war, says Roben Farzad in BusinessWeek. Killings and abductions have fallen sharply; one Bogota-based manufacturer of bulletproof apparel now sells just 20% of his wares in Colombia, compared with 70% a decade ago. Foreign direct investment has doubled since 2001 and, thanks also to commodity exports, the economy is now growing by 6.8% a year. The stock market too small for the S&P Frontier Index is up 14-fold since 2001. But, like all "extreme" emerging markets, it has been highly volatile because there are so few traders: it plunged 45% in early 2006's emerging markets correction. No wonder locals are only very slowly coming round to stocks.

It's not just volatility that frontier-markets investors have to watch out for. They are often "leaving the free market behind" and incurring political and property-rights risks, says Martin Hutchinson on Breakingviews. When global liquidity recedes, anti-market or corrupt governments become tempted to seize foreigners' money; witness Argentina in 2002. It took two decades for China to pay off foreign investors after it opened up in 1978; countries growing more slowly are thus correspondingly riskier. Many investments in frontier markets are "unlikely to survive the next downturn".