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
