October 2011

CAPITAL MARKETS: What every frontier country aspires to

FrontierThe United Arab Emirates and Qatar are tantalisingly close to being upgraded to the MSCI Emerging Markets Index. But where one other index provider is concerned, UAE already is an emerging market. Nick Fitzpatrick looks at the world of index classification.

What happens if the United States loses its status as a developed market one day? Logically, it would fall to emerging market status. But perhaps those who dole out such labels would invent a new category for countries that have slid from decades of sitting at the pinnacle of the economic pyramid.

Instead of “emerging markets” perhaps “exhausted markets” would be the most accurate moniker in the case of Europe and North America.

Reclassifying a country’s main stock market indices either upwards to developed market status, or downwards to emerging or frontier markets is one way for an economy to symbolically rise or fall. Fortunately, although the US has lost its AAA credit rating from Standard & Poor’s (S&P), no one is talking yet about demoting its stock indices from their currently enjoyed developed market status. Downwards reclassifications have recently happened though to other countries, namely Pakistan and Argentina.

Iconic index
Probably the most recognisable provider of these classifications is MSCI, whose range of indices are tracked by investors with around $3 trillion (€2.1 trillion) of assets. The MSCI Emerging Markets Index has been described as “iconic” and with so many assets tracking MSCI products it is no wonder, then, if every frontier country aspires to be in this index.

In the last couple of years, investors waited with bated breath to see if MSCI would reclassify its United Arab Emirates (UAE) and Qatar country indices as emerging markets. This would essentially upgrade them in the eyes of investors from their current status as frontier markets and potentially bring in vast sums of additional investment over time as benchmark trackers re-balance to match the index.

But it did not happen. Not yet. However, in June, MSCI said that it had extended the review period for reclassification of the two countries to December 2011. This is to give more time for market participants to assess the impact of the recent “positive changes” implemented in these two markets. The extension will also provide more time for regulators and stock exchanges to address the concerns raised by international institutional investors.

Tantalisingly, it seems a reclassification is close. But why so tantalising? Although the United Arab Emirates and Qatar do not need MSCI’s blessing for their economic well-being, a reclassification is generally expected to lead to more inflows of capital from emerging market investors, though this is not a given.

No seismic shift
Just as S&P is not the only credit rating agency, MSCI is not the only index classification provider. FTSE is one, S&P, again, is another, and so is Russell Investments, a company whose indices are evermore visible, but which is perhaps better known as an investment manager.

Where Russell is concerned, the UAE, which includes oil-rich Abu Dhabi, already is an emerging market, having been upgraded from frontier in 2008, and re-affirmed this year.

If a seismic shift of capital into the United Arab Emirates’ stock markets, which are located in Dubai and Abu Dhabi, did not take place when Russell reclassified UAE’s country index, then this may be because the Russell Emerging Market Index does not share the iconic status of the MSCI competitor.

It was Farley Thomas, head of exchange traded funds (ETFs) at HSBC in London, who described the index as iconic when announcing in September the launch of a London-listed emerging markets ETF that tracks it.

But providing indices is a competitive game and Russell is not standing still.

“It took Russell nearly 20 years to surpass S&P as the most widely used set of US institutional benchmarks, and our global success should be measured over a number of years as well,” says Scott Stark, head of Russell Indexes for Europe.

It was Russell that downgraded Argentina and Pakistan – from emerging market to frontier – and those countries felt the effects, he says.

“Pakistan and Argentina are two examples of countries recently downgraded from emerging market to frontier status and those markets suffered declines in liquidity and aggregate market capitalisation.”

Stark says the same would be expected if the reverse would be true of a graduation from frontier to emerging, because “it’s an affirmation that the country is moving into the core global investment opportunity set”.

In principle, a reclassification could have a net zero effect on a market. Consider a reclassification from emerging to developed, where the volume of capital from emerging market funds flowing out of a country’s index matches that coming in from developed market investors.

And reclassification can even lead to outflows in some cases, as Stark points out. “An emerging market country such as South Korea would likely see net outflows as they went from a large emerging markets index weighting to a smaller weighting within developed market indexes.”

Positive inflows for Israel were predicted at the time of its MSCI reclassification from emerging to developed, which was announced in June 2009 and became effective from May 2010. In 2009, Merrill Lynch estimated that reclassification would bring $2.8  billion into the local market through passive investments managed through ETFs over time – albeit 75% of that money would be invested in just three stocks.

Elevation
If the United Arab Emirates were to elevate to an emerging market in the eyes of index providers, it would join the likes of Egypt, which is an MSCI and a Russell emerging market. Despite the recent Egyptian uprising, MSCI feels that operational issues regarding the stock exchange are not affected and so Egypt will keep its status.

Stark would not be drawn on why Russell gives the United Arab Emirates emerging market status while MSCI does not, saying he could not comment on MSCI’s methodology. But he says: “Russell operates a methodology-driven approach which seeks to objectively identify the relative risk of investing in a country by evaluating both macro-level and market-level factors.”

If it happens, a reclassification of the MSCI Qatar and United Arab Emirates indices would be implemented at the earliest as part of the November 2012 semi-annual index review.

MSCI said in June that international institutional investors are assessing the effectiveness of measures to eliminate dual account structures, which would increase efficiencies.

Concerns about the handling of failed trades, which could prevent them from adopting the single-account structure, have been raised. And concerns that centre on foreign ownership rules have also been voiced, particularly about Qatar.

Whereas Russell has given approval for the UAE to be an emerging market, Qatar, the country for which there are also hopes of an upgrade, remains in Russell’s frontier index, where many other Mena countries also sit.

©2011 funds global

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