Over the next quarter-century, today’s frontier markets are projected to add more individuals to the global population than the rest of the world combined—making them pivotal to the global job creation agenda. This diverse group of 56 economies generally has more access to international finance than other developing economies, though not as much as emerging markets or advanced economies. The extent to which these economies can leverage this access to drive growth and improve living standards will shape outcomes not just in frontier markets, but for development prospects globally.

Yet despite having enormous potential, frontier markets have delivered mixed results over the last 25 years. The central question is no longer whether to integrate with global financial markets, but how to manage the risks that emerge when they do. Our new research includes seven key insights relating to these opportunities and risks, and considers what policy makers can do about them.
 

Frontier markets and the global financial cycle

The analysis uses a dynamic factor model to decompose monthly equity returns across three groups of economies—advanced economies, emerging markets, and frontier markets—into global, group-specific, and country-specific components. The global factor can be interpreted as a measure of the global financial cycle in equity markets.
 

Insight #1: Overall, frontier markets remain substantially less synchronized with the global financial cycle than their emerging market and advanced economy peers.

Between 2000 and 2025, the global factor accounted for only about 12 percent of the variance in frontier market equity returns, on average, compared to 46 percent for emerging markets and 64 percent for advanced economies (figure 1). Around 80 percent of frontier market equity return variation is driven by country-specific factors. This low average synchronization suggests portfolio diversification opportunities for investors, especially outside periods of global stress.

Insight #2: During periods of global stress, a larger share of frontier market equity returns is explained by global conditions.

During calm periods, global risks are relatively stable, and local developments drive most of the movement in frontier market equity prices. During episodes of global financial stress, by contrast, global risk rises sharply. This larger common shock becomes a much more important driver of frontier market returns, though country-specific factors remain the biggest source of variation.

Between 2007 and 2012—spanning the global financial crisis and euro-area debt turmoil—the share of frontier market equity movements explained by global factors nearly tripled, to about 30 percent (figure 2). The role of the global component also became more prominent during the COVID-19 period.
 

Surges and stops in capital inflows to frontier markets

Global “push” factors and domestic “pull” factors both shape dynamics in capital inflows. Stronger domestic fundamentals increase the likelihood of a surge, but surges are also more likely during periods of ample global liquidity and can reverse quickly if global financial conditions tighten. Surges are associated with higher domestic GDP growth, but they can also create challenges for macroeconomic management and are often followed by sudden “stops,” which can undermine macroeconomic stability and weigh on growth.

Insight #3: Frontier markets have been particularly prone to extreme shifts in portfolio inflows compared to other country groups.

In the 2010s, the share of frontier markets experiencing a portfolio inflow surge or a stop in a given quarter averaged 14 percent and 10 percent, respectively—a far higher share than in either advanced economies or emerging markets (figure 3). The higher incidence of surges is consistent with growing portfolio inflows to frontier markets during the 2010s, driven in part by their inclusion in global equity and bond indexes and by global investors’ search for yield and diversification. The share of frontier markets experiencing stops in portfolio inflows remained high in the early 2020s, even as surges became less frequent.

Insight #4: Surges in capital inflows to frontier markets are often followed by stops, especially for portfolio inflows.

Since 2000, frontier markets have been nearly twice as likely to experience a stop in aggregate capital inflows in the aftermath of a surge episode than at other times (figure 4). This risk is particularly acute for frontier markets’ portfolio inflows, where the probability of a stop rises to 57 percent following a surge, up from just 16 percent.

Debt and default dynamics in frontier markets

Insight #5: As a share of GDP, sovereign debt issuance by frontier markets has been relatively large and growing.

Borrowing on international markets is an important potential source of financing for frontier markets, made possible by their market access relative to other developing economies. In recent years, sovereign issuance as a share of GDP in the typical frontier market has risen to over 3 percent of GDP, twice the level of the median emerging market (figure 5). 

Insight #6: Frontier markets have experienced rapidly rising—and more foreign currency-denominated—debt.

Government debt has risen across country groups in recent years, but the rise has been especially pronounced among frontier markets. Since the global financial crisis, most frontier markets have recorded debt-increasing primary balances. Accordingly, debt-servicing costs in the median frontier market have grown to over 2.5 percent of GDP, higher than in the typical emerging market or other developing economy. Moreover, the composition of frontier market debt reveals potential vulnerabilities. Foreign currency-denominated debt as a share of GDP has seen a particularly steep rise among frontier markets, for example. This can exacerbate an economy’s exposure to global shocks, especially in the absence of effective policy responses. 

How should policy makers in frontier markets respond?

Frontier markets need to strengthen their capacity to manage shocks and periods of volatility. The report highlights three broad policy themes:

• Advancing financial integration carefully while taking steps to mitigate associated risks. Economies embracing global integration and capital account openness—which can bring important benefits—also need to develop capacity to help cushion abrupt shifts in capital inflows. Possible policy measures include accumulating buffers during calmer periods, deepening domestic financial markets, and strengthening oversight capacity.
• Bolstering macroeconomic stability and credibility, including by strengthening fiscal resilience. Stronger institutional capacity, including improved fiscal policy and debt management, is key to establishing an enabling environment for business, investment, and effective financial integration.
• Catalyzing investment and productivity growth. This requires the right foundational infrastructure, robust institutions, and structural reforms to help lay the groundwork for sustained productivity growth and job creation.

Frontier markets are diverse, and policy priorities will vary according to each economy’s comparative advantages and vulnerabilities. The international community, including the World Bank Group, can help foster the conditions for strong development progress in these economies.

Source : World Bank