Thursday, 13 August 2015

EMERGING MARKETS “EM” – Re look at the Definition




EMERGING MARKETS “EM” – Re look at the Definition

It is time to redraw the world’s mental map as the consumption and economic growth is dominated by the so called developing nations.
Emerging markets is one of the most powerful definitions in the world and accounts for investment of more than $10tn. But with developing markets overtaking developed ones in some areas as its time to look at a better economic classification.

The current economic hierarchy, which places emerging nations at the periphery and developed markets at the core of world affairs, no longer accurately describes a world in which EM countries contribute a bigger share to global gross domestic product than their developed counterparts, when measured by purchasing power parity.

Emerging Markets is the term that embraces big and small, developed and under-developed, industrialized and agrarian, manufacturing and commodity-based, rich and poor, deficit runners and surplus runners, under one classification.  Emerging markets is one of the most powerful definitions in the world, with an estimated $10.3tn invested in emerging financial markets via an equity and bond indices. But these indices embrace such a collection of incongruous assets, that they misdirect investors and potentially reduce returns to pension funds, insurance companies and other financial institutions.

Investor attraction was clear: it sounded aspirational. Countries previously known by monikers such as less developed or third world were suddenly imbued with the promise that they might be on a journey towards something better and the economic growth in these emerging countries would result in superior risk adjusted returns for the investors hence in the last decade or so huge amount of investment interest was shown in most of the EM countries.

Adding to the confusion, the term is sometimes used to describe equity, bond or currency markets in developing countries and sometimes to describe the countries themselves. Different criteria make a world of difference. The MSCI equity index identifies 23 emerging markets countries and puts 28 into a “frontier emerging markets” category. The IMF, by contrast, defines 152 “emerging and developing economies”.

Even accepting prevailing classifications, it is often unclear why one country has been awarded emerging status while another merits a developed tag. Chile has a bigger economy, a bigger population, less debt and lower unemployment than Portugal but is classed as emerging, whereas the European nation remains part of the developed world. Similarly, on a per-capita income basis, Qatar, Saudi Arabia and South Korea are wealthier than several developed countries, but are still consigned to the emerging camp.

Such judgments often depend on the classifier. Providers of financial indices look at issues such as the freedom with which international investors can access the stocks and bonds of a particular country. Others such as the IMF consider questions about the diversity of a country’s economy, in terms of how many products they import and export. Increasingly, the sense that emerging nations take their lead in global affairs from the so-called developed world is also under examination. In some senses, emerging economies already wield power. When calculated by purchasing power parity, which takes account of exchange rate changes, developed countries account for only 39 per cent of global GDP, down from 54 per cent in 2004.

Developed markets are also weaker, in aggregate, when it comes to the size of their foreign exchange reserves, the huge stashes of money that accumulate when a country notches up trade surpluses and attracts foreign direct investment. Developed markets hold $3.97tn, compared with $7.52tn for developing countries, according to IMF data.

This leads to the curious situation in which emerging nations, which need to invest their reserves in large liquid debt markets, have ended up bankrolling years of deficit-financed excess in large developed countries. China, for instance, was the biggest foreign buyer of US Treasury debt for six years until early 2015.

The composition of the countries within the Emerging Markets basket is so diverse that when it comes to economic indicators the differences between emerging markets outweigh their similarities.
For instance, capital investment makes up 20 per cent of GDP in Mexico, but 45 per cent in China. Household consumption makes up 50 per cent of GDP in South Korea but 70 per cent in Turkey, the populations of China and India are similar in size but their demographic trends are very different. So is the corporate landscape; 60 per cent of Latin America’s corporate revenue is held by family controlled firms but in India it is 50 per cent and in China 30 per cent.

  

China breaks the mould as far as EM classification is concerned the problem of how to classify China highlights the emerging market dilemma. In PPP terms, China is already the world’s largest economy and yet it is still classified as emerging. The country has a literacy rate of 96 per cent, more high-speed rail track than all other countries combined and more college students than any other country.   Its near $8tn stock market is the world’s second largest after the US and its $5.5tn domestic bond market ranks third in the world after those of the US and Japan. Nevertheless, its domestic equities — not counting those listed in Hong Kong — and its bonds feature only marginally in the MSCI EM Index and JPMorgan EMBI+, the world’s leading equity and bond indices.   As a result much of the investment opportunity and risk that Chinese assets represent remains largely sequestered from global investors

  
Inducting even a mere slice of the huge Chinese stock and bond markets into emerging market indices would create a financial earthquake, effectively forcing fund managers with ambitions to match an index’s performance into loading up on Chinese assets.


China is so enormous that if it goes fully into EM indices it will dwarf everything, so it is required to treat China as a separate category is what many professional investors are of the view of most professional investors. 

 
Emerging Markets like Brazil and Russia — are no longer emerging in an economic sense but rather regressing at a rapid clip. For another, the sense of equivalence that the term bestows on the countries under its umbrella is entirely bogus. Qatar, the United Arab Emirates and Taiwan all boast a gross domestic product per capita that is higher than that of the UK, but find themselves occupying the same definitional space as India, the Philippines and Indonesia.


Going forward its time that the classifying agencies re look at the definition of Emerging Markets so that a better mental map of the word can be re drawn which would help asset allocation for large fund houses who predominately look at investing in emerging market index funds and sooner this reclassification takes place the better risk adjusted returns will the investors make who look at these markets.


-       Farzan Ghadially

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