A frontier market is a developing country that has not yet achieved the status of an emerging market. Consequently, its capital Markets are less advanced in terms of risk management, liquidity, and regulatory frameworks. While these are more developed than the least developed ones, they do not qualify as emerging Markets due to insufficient capital flow, market liquidity, and overall economic and political stability.
Investors often find frontier Markets appealing for long-term investments because of their potential for future growth. However, companies in these Markets are typically new and have limited track records. The frontier market designation helps investors assess whether a country meets their investment criteria, allowing them to make more informed decisions based on their investment goals and objectives.
What’s the default experience for investors regarding frontier Markets and how does one manage this risk?
Each instance of sovereign default is unique, shaped by a complex interplay of economic, political, and social factors. The decision to default is ultimately a policy choice reflecting a balance of competing interests in these areas, which means political considerations play a crucial role in shaping debt repayment decisions. This “willingness to pay” aspect highlights the importance of understanding the political context when managing default risk.
For example, Jamaica faced a debt burden exceeding 120% of GDP a decade ago and seemed a prime candidate for default. However, the political decision was to pursue rigorous fiscal consolidation, reducing the debt ratio to about 78% of GDP. In contrast, Argentina’s response was different. Despite receiving fiscal relief from bondholders during the COVID-19 pandemic, the Fernandez administration used this opportunity for politically motivated spending, leading to a less sustainable fiscal situation. Therefore, comprehending a country’s political incentives is crucial for assessing default risk.
Despite the unique aspects of each sovereign default, there are common patterns. Elevated external vulnerabilities in sovereign balance sheets often signal a higher risk of default, particularly when countries rely heavily on external capital to avoid liquidity crises. Many defaults observed during the 2020 COVID-19 pandemic and the 2022 period of geopolitical and economic upheavals (e.g., the Russian invasion of Ukraine, Fed interest rate hikes, and China’s economic retrenchment) involved countries with significant external vulnerabilities facing external shocks.
Consequently, while sovereign defaults are relatively rare, they tend to occur in response to specific, significant external pressures, such as fluctuations in commodity prices or shifts in global financial conditions.
Characteristics
1. Size of the Country
Countries with a high development quotient but still too small to be classified as emerging Markets are categorized as frontier Markets.
2. Restricted Markets
Financial Markets that have historically had limitations on the free flow of capital but have been gradually easing these restrictions fall into this category. Restrictions may include foreign investment limits, investor rights, and information flow, impacting market accessibility.
3. Development
Countries with lower growth rates compared to those in the emerging Markets bracket are considered frontier Markets.
4. Liquidity
Frontier Markets typically have lower liquidity due to fewer market participants.
5. Risk
Investments in frontier Markets carry high risk because these Markets consist of relatively new companies with limited track records. Investors often engage in joint ventures, involving significant participation in daily operations, which contributes to higher investment risk and potential rewards.