In June, major international equity index provider MSCI confirmed Greece’s sojourn among the ranks of “developed markets” would end later this year as it will become the first-ever country to lose its “developed market” status in the MSCI universe.1 Interestingly, Greece was classified as emerging when I started with the Templeton Emerging Markets Group in 1987, and while the recent news might conjure up images of a significant turn for the worse for the country’s economic fortunes, MSCI’s explanation for Greece’s reclassification was actually more mundane.
The division of MSCI’s equity universe into separate “developed,” “emerging” and “frontier” indexes was originally conceived in response to the arrival on the world scene of countries in various stages of economic development. In order to be classified as a developed market, a country’s gross national income (GNI) per capita has to have been at least 25% higher than the World Bank’s threshold for a country to be in a “high income” (i.e. developed) category for three consecutive years.2 That would equate to US$15,600, given the World Bank threshold stood at US$12,475 as of 2011, the latest year for which data are available. Despite several years of wrenching recession, Greek per capita GNI has been far in excess of this figure.3Indeed, several emerging and frontier markets would meet this criterion. Therefore, MSCI’s economic development requirements for index inclusion were not the issue for Greece, but other factors relating to the ability of international investors to easily enter and operate in the market proved important.
*GDP figure represents rate of growth/contraction
The Greek Tragedy
According to MSCI, for an international equity index to fulfill its purpose, investors, including passive “index” vehicles, must be able to buy and sell its component companies with a degree of ease and confidence.4 To this end, MSCI has a number of criteria including explicit requirements for market size and liquidity, and somewhat more subjective targets, including a country’s openness to foreign ownership, restrictions on foreign currency trading that might hamper repatriation of funds and availability of mechanisms to facilitate trading. Greece has failed both the MSCI size and accessibility tests for inclusion in the developed index because of the Greek stock market collapse since 2007, and the subsequent re-listing elsewhere of some key companies which left the Greek market containing too few large and liquid stocks to allow major investors to take adequate positions. In addition, the Greek stock exchange authorities have failed to match developments in other markets in areas such as stock borrowing and lending, short selling and transferability, making the Greek market relatively difficult to do business in.
Despite Greece’s problems, we still see potential long-term opportunities there. However, just because Greece will become part of the emerging market universe again does not necessarily mean we are rushing out to buy Greek stocks immediately. A key aspect of our investment philosophy is that we are not constrained by considerations of index weighting, and although we will pay attention to a country’s macroeconomic fundamentals, our allocation decisions are based primarily on individual companies’ long-term value and potential prospects. We see some faint signs that Greece’s challenging economic ordeal might be reaching a turning point, and we will look at the possibilities for investing. The key, of course, is to find stocks that meet our value criteria.
A China Addition?
While Greece’s reclassification made headlines, perhaps the most striking MSCI announcement did not involve an actual change, but one that may be on the horizon. China’s domestic “A” share market probably won’t become part of an MSCI index any time soon; however, the idea that it might become eligible at some point is potentially of tremendous significance given the very large size of the market compared to the internationally traded “B” and “H” share markets.
MSCI’s commentary on the subject emphasized huge obstacles remaining to the “A” share market joining the MSCI index family, notably the limitations of the “qualified foreign investor” quota system as a means of providing access and a level playing field for foreign investors, ongoing restrictions on foreign exchange trading and uncertainty about taxation. Nevertheless, as investors we should be aware of, and excited by, the prospect that a vast and dynamic market may eventually become more available.
Movin’ on Up
Meanwhile, South Korea and Taiwan remain under MSCI review for promotion to developed market status. In terms of economic development and market depth, we think both easily qualify to upgrade, but idiosyncrasies in their foreign exchange markets and stock identification systems worry large institutional investors, causing South Korea and Taiwan to fail the market accessibility test. We feel that the South Korean and Taiwanese economies are so intimately meshed with their emerging neighbors that their presence in emerging market indexes currently makes good sense.
In the Middle East, the long-anticipated promotion of the Persian Gulf states Qatar and the United Arab Emirates to emerging from frontier market status was confirmed, while issues of accessibility led to Morocco’s reclassification to frontier status.
We should again emphasize that these developments are not likely to lead to any major short-term changes to the composition of our emerging and frontier market portfolios. These shifting sands certainly keep things interesting, but the MSCI class switches won’t take effect until 2014, and regardless, making sharp turns isn’t generally our style. Still, we are definitely eager to see more investor attention drawn to these dynamic markets.