By 2040, China is projected to overtake the United States as the world’s largest economy. To investors and companies, this prospect is exciting, representing a wealth of new investment opportunities.
But for that projection to become a reality, emerging markets must first undergo huge economic and institutional transformations, said Christian Lundblad, the Edward M. O’Herron Distinguished Scholar and professor of finance at UNC Kenan-Flagler.
A former financial economist at the Federal Reserve Board, Lundblad’s research gives insights into the risks and opportunities of emerging market investment.
“Those economies will have to be completely different animals,” he said. “There will have to be a significant shift in their institutional environments, and all that defines the political situations in these countries now.”
Lundblad presented the opportunities and challenges of emerging markets during a webinar hosted by the Global Business Center at UNC Kenan-Flagler.
Political risk and institutional differences — such as exchange rates, interest rates, tax systems and legal systems, among others — can be obstacles for foreign investors, he said. “When we put all that together, that’s just a collection of risk sources that tend to be somewhat more pronounced than what we’re familiar with.”
The massive restructuring includes further developing financial systems, increasing domestic consumption and reducing corruption so that money can be funneled into the best projects.
On the economic side, many emerging markets such as China are pouring a disproportionate amount of money into savings and not enough into domestic consumption, Lundblad said. Just as too much money being spent and not enough saved has troubled the U.S. economy, this creates an economic imbalance.
“The Chinese are delaying a lot of consumption into savings,” he said. “It’s not sustainable.”
Corruption, nepotism and other political problems also create challenges for investment within emerging markets.
“In China, in India, all across the emerging world, the financial intermediary system is notoriously in the pockets of certain people,” he said. “So there’s corruption, there are relationships and connections. It’s very difficult for savings to find its most productive ends.”
“At best it’s a tax on economic activity,” Lundblad said. “At worst, the uncertainty that comes with corruption creates additional impediments to investment in the first place.”
And political and social uncertainty, such as the ongoing conflict in Ukraine, can make investment risky. Lundblad cited kidnapping, terrorism and government nationalization of industries as potential country risks.
Balancing the multitude of institutional, social and economic risks that come with emerging markets can be difficult for investors.
That’s where Lundblad’s research comes in. By analyzing the interest rate a country gets on its loans — which inherently accounts for many of these risks — Lundblad has been creating a decision-making model for investors and companies that weighs the risks of foreign investment against the opportunities.
Lundblad stresses the importance of continuously reevaluating these risk factors, as many emerging market economies are volatile and can be greatly impacted by economic changes in other countries. The U.S. recession shattered any notion that the economies of emerging markets are isolated, he said.
Since the start of the recession, an immense amount of capital has become available as interest rates fell dramatically and central banks issued more money, he said. Much of this capital was invested into emerging markets.
Now, as the Federal Reserve prepares to start the tapering process to bring interest rates back up to normal levels, the flow of capital is being reversed.
“All that money that had previously flowed into the emerging world is now on its way back,” he said. “This has sent emerging worlds into a rollercoaster ride.”
The growth of emerging markets also brings up long-term questions, such as if the world has enough resources to support these growing economies and the increased standards of living that come with economic growth.
Lundblad questions the feasibility of the world energy consumption required for these forecasts in 2030 and after. “We’ve always tricked our way out of these kind of resource constraints, through innovation and productivity. However, that process is unpredictable and there are no guarantees.”
Lundblad’s webinar is part of the “Best Practices in Global Business Education Webinar Series” offered by the Global Business Center at UNC Kenan-Flagler. Read more about his research in the R.O.I. article “Investors without borders.”