What is Frontier Market?

Explanation

In 1992, Farida Khambata of the IFC Emerging Markets Database published underdeveloped and developing markets. That was when this categorization first emerged. In 1999, S&P purchased the rights to the same publication. Later in 2007, it launched two indices focused on frontier markets: Select Frontier Index and Extended Frontier Index. Eventually, the competitor index publishing companies, such as the MSCI, found their versions. 

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Characteristics

  • Size of the Country: If a country has a higher development quotient but is still very small to be categorized as an emerging market country, it is put in the frontier market bracket.Restricted Markets: Those financial marketsFinancial MarketsThe term “financial market” refers to the marketplace where activities such as the creation and trading of various financial assets such as bonds, stocks, commodities, currencies, and derivatives take place. It provides a platform for sellers and buyers to interact and trade at a price determined by market forces.read more which previously had restrictions on the free flow of capital. Still, in the past few years, such limits have been on a reducing trajectory that falls under this category of markets. These restrictions can be in the form of foreign investmentForeign InvestmentForeign investment refers to domestic companies investing in foreign companies in order to gain a stake and actively participate in the day-to-day operations of the business, as well as for essential strategic expansion. For example, if an American company invests in an Indian company, it will be considered a foreign investment.read more limits, rights of foreign investors, information flow, and so on. These determine the level of market accessibility.Development: The countries with lower growth than those presently categorized as emerging markets form part of this market.Liquidity: As there are fewer market participants who want to invest their money in such a market, the liquidity for the assetsLiquidity For The AssetsLiquidity is the ease of converting assets or securities into cash.read more of this market is low.Risk: As such markets comprise very young companies with a lesser track record, the investmentInvestmentInvestments are typically assets bought at present with the expectation of higher returns in the future. Its consumption is foregone now for benefits that investors can reap from it later.read more risk is very high. Most investments are in the form of joint venturesJoint VenturesA joint venture is a commercial arrangement between two or more parties in which the parties pool their assets with the goal of performing a specific task, and each party has joint ownership of the entity and is accountable for the costs, losses, or profits that arise out of the venture.read more in which the investor plays a large part in the companies’ day-to-day activities. Therefore, the risk and reward are very high for investments in such markets.

Based on these criteria, MSCI and S&P classify countries and their financial markets.

How Does it Work?

According to the MSCI June 2014 Market classification framework, based on the above characteristics, the following is how a country is categorized into the frontier market category: –

  • Under the frontier market and emerging markets, there is no requirement for sustainable economic development. This point is to restrict the developing markets from the developed market. The World-bank categorization of the high-income threshold is based on the per capita gross national income, which should be $12,615 per the limits published in 2012 using the Atlas method. If a country has a per capita GNI greater than the threshold by 25% for three consecutive years, it falls under the developed category; otherwise, it is a developing country.The size and liquidity categorization is as follows:

  • Based on the restriction posed by the market and the accessibility level, the following is the categorization: –

Other players, such as the S&P, have a similar framework for categorizing countries into different markets.

Example

All index publishers periodically review and reclassify various economies for upgrades or downgrades from one market to another. For instance, as per the results published by the MSCI in June 2019, the MSCI Kuwait index was reclassified from frontier market to emerging market index if it meets the required criteria by November 2019. In addition, it posted the launch of the market development program in Kuwait, which would lead to the necessary regulatory upgrades and reduction in market restrictions.

As per the Reuters update, FTSE Russel concluded on September 26, 2019, that Argentina would continue to be categorized under the frontier market only because of the imposition of capital controlsCapital ControlsCapital Controls are measures taken by the central bank, government, or other relevant bodies that limit the inflow or outflow from the domestic capital markets. These controls are specific to an industry or sector or even economy-wide.read more. In addition, it was due to the political and economic instability following the elections in the country which led to the fall in its currency and bond value. MSCI, on the other hand, has upgraded its classification to an emerging market but is reviewing and monitoring the economy in real-time to publish a review.

Several countries, such as Mauritius, Nigeria, Tunisia, Sri Lanka, and Vietnam, fall in this market bracket.

Difference between Frontier Market and Emerging Market

  • Economic and Political Stability: Emerging markets have greater stability than the frontier market.Movement of Capital: Emerging markets are more accessible to foreign investment. Therefore, the movement in and out of the economy is greater.Risk and Liquidity: Emerging markets are more liquid and less risky.The Breadth of Financial Instruments: Many financial instruments are available in emerging markets, such as derivatives. In contrast, the availability of such instruments and an active market for the same is less likely in the case of frontier markets.

Why Invest in Frontier Market?

  • Very high return:  As a venture capitalVenture CapitalVenture capital (VC) refers to a type of long-term finance extended to startups with high-growth potential to help them succeed exponentially. read more investment, the expected reward is very high if the project or the company is successful. When it comes to an investment in such markets, as the fund requirement is very high and investor competition is low, the chances of capturing a greater market share are high. Such an investment is like a double-edged sword. Risk and reward are both very high.Growth prospects: As these markets are initially, investors can benefit from an initial period of very high growth.Diversification: As developed markets get saturated, frontier markets provide diversification benefits because it provides exposure to a new economyNew EconomyNew Economy refers to industries that use innovative and cutting-edge technologies that boost industrial production and economic growth.read more with a hopeful and growing trajectory compared to the cash-cow nature of mature markets.

Conclusion

The frontier market is a term given to a developing market. Still, it has not reached the level of development required to be categorized as an emerging market due to a lack of free flow of capital, liquidity in the market, and another measure of economic and political stability.

Such categorization signals to the investor community whether they can think in the direction of investing in such economies based on the goals and objectives of their investment. Therefore, it helps in making an informed investment decision.

This article has been a guide to what is frontier market. Here, we discuss characteristics, how it works along with an example and why to invest in them. You can learn more about financing from the following articles: –

  • Commodity MarketEfficient Frontier DefinitionFinancial Markets ClassificationDealer Market