The Risky Capital of Emerging Markets

Ina Simonovska is an assistant professor of economics. Her project, which explores the riskiness of investments in poor relative to rich countries, was awarded an ISS Individual Research Grant in 2015. She provided this update in March 2016.

What motivated you to pursue this project?

The motivation for this project is the observation that expected returns to investments in physical capital in less developed markets are relatively higher than those in developed ones; yet investors do not appear to take advantage of these disparities by investing more in the former countries than in the latter. We hypothesize that the main explanation lies in the difference in the riskiness of investments in poor relative to rich countries rather than the existence of differential barriers to investment across markets.

How has it progressed since you received an ISS Individual Research Grant?

Over the course of the past year, we obtained supporting evidence for our hypothesis. We completed the research paper and we submitted it to an academic journal for publication. In addition, we completed a follow-up paper, inspired by the analysis conducted in this project. The paper has been published in a top field journal.

What notable or surprising findings can you share at this point?

Several surprising results came about. We found that returns to different types of assets obey the same regularities as returns to investments in physical capital. For example, returns to equities (stock market) are higher in emerging than developed markets. The same is true for yields on sovereign bonds. These findings suggested to us that there exists a unifying factor that is responsible for the systematic difference in expected returns between rich and poor countries across various classes of investments.

We found convincing evidence that the factor in question is risk. We observed that countries where expected returns to any asset are higher are those that are more exposed to the same types of shocks that drive returns to the equivalent asset class in the U.S. It is in this sense that investments in poorer countries are riskier. The observation was surprising to us because it is fairly well-know that macroeconomic aggregates of the U.S. are more highly correlated with those of rich than poor countries.

However, the volatility of poor country’s macroeconomic variables far exceeds that of rich; hence, the covariance of poor countries’ macro aggregates, such as returns, with those of the U.S. is higher. Since these covariances reflect exposures to shocks in standard theoretical models and these exposures in turn reflect riskiness from the point of view of a U.S. investor, we conclude that poor countries’ investments are riskier.

What is the next step?

We are currently digging deeper to uncover the sources of risk in poorer countries; namely, the types of shocks that these countries are exposed to and the channels through which they react so strongly to these shocks. Some hypotheses include the high dependence of emerging markets on commodity exports, whose pries they take as given on world markets, poor institutions in these countries that lead to overreactions to adverse shocks, etc.

Learn more about Ina Simonovska at her faculty webpage.