As gloom besets capital markets in the developed world, the prospects of emerging ones continue to shine.

The credit crunch that erupted in mid-2007 has already taken many new twists in the first half of 2008. But new McKinsey research shows that, amid the general uncertainty, the outlook for investment banking in emerging markets remains relatively bright. Full report by Mckinsey

Even in the worst case, emerging Asia and Europe, the Middle East, and Latin America will probably show absolute revenue growth over the next three years. Under all likely outcomes, the proportion of global revenues from emerging markets will jump sharply. Collectively, indeed, revenues from investment-banking and capital market activities in these regions are projected to match those in North America by 2010; in 2006, before the credit crunch, they amounted to less than half. A case, perhaps, for referring to “emerged” rather than emerging markets in the future?

Exactly when capital market activity recovers around the world will depend on three critical uncertainties: the prospects for the US and global economies, the speed of recovery in credit markets, and the behavior of investors and regulators. But several factors already suggest that emerging markets will be big winners in the near future. First, their macroeconomic environment remains comparatively benign, even if talk of a complete “decoupling” of their economies from those of the United States and Western Europe was premature. Although, if trade flows with the West do suffer, regional demand for oil and commodities, growing intra- and interregional trade flows (especially within Asia and between it and the Middle East), and huge infrastructure-investment programs will continue to underpin growth. Second, a new breed of global corporate players, notably in countries such as China, India, and the United Arab Emirates (UAE), now demands the sort of sophisticated investment-banking services previously reserved for large Western multinationals. This new group thus represents an increasingly attractive fee pool.

On the supply side, the emerging world’s capital markets will continue to develop. In part, their growth reflects intraregional competition, seen in the rush to develop financial centers in the Middle East and in government-sponsored bond issuance programs. At the same time, global investment banks are redirecting their resources—both human and capital—toward emerging markets, which they see as a new source of revenues to compensate for leaner times at home.

In the event of a relatively benign outcome for global capital markets—a one-year setback, with growth resuming in 2009—we calculate that revenues from investment banking in emerging markets will increase by 16 percent a year from 2007 to 2010, when they will generate 28 percent of the global total (exhibit). In this “steady recovery” scenario, Asia will continue to represent the lion’s share (66 percent) of the emerging markets’ revenue stream of almost $120 billion.

Suppose that the industry contracts more sharply during the second half of 2008, with a much slower, even faltering recovery in 2009. Revenues from emerging markets will still rise significantly (6 percent), according to our research, and will probably exceed $90 billion by 2010. In this “long chill” scenario, these regions will account for a bigger share of the global total (30 percent) than they would under our more benign scenario.

What’s really likely to distinguish emerging and developed markets over the next few years is the different effects of the credit crunch. Emerging markets, after all, do not have as much fallout to manage as their Western counterparts do: by the end of the first quarter of 2008, they had generated only around 7 percent of investment banks’ write-downs, as opposed to more than 21 percent of global revenues. Furthermore, revenues from credit and securitization—mostly plain-vanilla corporate bonds—represented just 9 percent of the emerging markets’ revenue pools in 2007. By contrast, credit products were responsible for 18 and 10 percent of US and European revenues, respectively.

Of course, one could argue that these numbers do not tell the full story. With limited product origination in emerging markets, there has been little to securitize, and institutions there have consequently avoided the dramatic swings in valuation that have hurt their counterparts holding market-traded products in the developed world. Even if many institutions hold significant amounts of bad loans, they are not required to mark them to market.

The absence of a bond “culture” means that managers of institutions based in emerging markets can now focus harder on the areas most likely to generate future growth. Under our analysis, commodities and equity derivatives will probably be the big winners, no matter how markets perform more generally. Foreign exchange, interest rate swaps and futures, and equities (including derivatives) will do well under our benign scenario and will be relatively resilient even in the tougher one.

While all emerging markets are expected to fare comparatively well under both scenarios, we see some interesting nuances across regions.

Emerging Asia

Over the next few years, we expect wholesale banking revenues ($38 billion in 2006) in Asia outside Japan to double under our steady-recovery scenario and to increase by more than 60 percent even with a long chill.

Drivers will include robust economic growth—increasing both the stock and turnover of financial assets—and further deregulation in local markets. Emerging Asian countries, moreover, will integrate with global financial markets and become a target for financial players; as more Asian companies expand internationally, they will also become a source of new investments, funds, and wholesale-banking activities.

Sovereign wealth funds and hedge funds have emerged as new client groups and are growing rapidly, with the $200 billion fund of the China Investment Corporation (CIC) just one of the latest actors on the stage.

Indeed, China is the country to watch: its financial depth is already comparable to many developed markets. Its future growth will be mainly built around equities, rates, and an emerging debt capital market and corporate-bond market, as well as an appreciating currency, which should further boost revenue pools. Product diversity and innovation will increase in China: advanced products such as securitization, derivatives, and program trading should start to thrive as regulators continue to loosen restrictions.

India’s growth is also expected to be strong under both our scenarios, with M&A and rates trading comparatively more important than they are in China. That said, lower growth and lower savings rates mean that India’s accumulated financial stock will be only one-fifth of China’s.

Asian markets are fast becoming as demanding and sophisticated as markets in Europe and the United States. Clients have developed a taste for complex financial products and demand good local service; domestic competitors are ramping up their skills and opening their checkbooks to attract international talent.

An onshore presence in emerging Asian markets, meanwhile, is becoming critical. The old model of the suitcase banker operating from hubs such as Singapore and Hong Kong will fail to satisfy clients and regulators seeking a true commitment to the local market.

Complex products (acquisition finance, exotic fixed-income products, equity derivatives, and proprietary trading) will develop in emerging local onshore markets and continue to grow in the bigger financial centers. As elsewhere, the lines between financial services are blurring with increasing overlap between investment banking, asset management, and private banking. A significant share of private wealth in Asia, after all, is generated through capital markets transactions.