The period of easily raising funds from abroad seems to be coming to an end for emerging markets around the world. In the new environment of higher interest rates in the US and increased competition for capital flows, portfolio managers are becoming more selective with where they place their money.
One way for developing nations to ensure that their financial markets can continue to attract foreign funds and remain sustainably liquid is by being included in visible and well-regarded benchmark indices. In addition to drawing in fund managers, inclusion on such indices requires specific standards that indicate to investors that the participating countries apply certain regulations and best practices.
For two countries, 2018 is proving to be a pivotal year in how they are viewed by the global financial community. On June 20 stock market index provider MSCI granted Argentina and Saudi Arabia emerging market status – upgrading Argentina from a frontier market and including Saudi Arabia in its indices for the first time. Speculation during the lead-up to the MSCI announcement resulted in a large amount of research by banks and brokerages, countless financial press articles and comments from Luis Caputa, the previous minister of finance of Argentina. Confidence in both countries’ capital markets proved to be well placed with the mid-year move.
Prior to this, FTSE Russell, another global index provider, gave Saudi Arabia a boost by upgrading it from frontier to emerging market status on March 28. The announcement significantly increased the probability of MSCI doing the same, Fahad Al Turki, chief economist and head of research at Riyadhbased Jadwa Investment, told OBG.
Argentines, meanwhile, were also optimistic heading into 2018. The feeling was based on MSCI’s June 2017 report maintaining the country’s frontier market status. The index provider noted that although Argentina had already met most of the emerging market criteria, the positive changes instituted by the country regarding market accessibility factors needed to remain in place for a longer period of time to be deemed irreversible.
Argentina’s pro-business government subsequently solidified a majority in the October 2017 mid-term legislative elections. Even though challenges remain, demonstrated by a drastic sell-off of the peso between late April and June 2018, MSCI felt confident that Argentina would not be returning to its practices of market interference.
A Closer Look
Some may wonder why such classifications are of importance to a country’s financial environment. FTSE Russell and MSCI have specific criteria they use to determine whether a country is classified as frontier, emerging or developed, including size and liquidity measurements, and market accessibility factors. Frontier nations display characteristics that, when taken together, translate into a riskier bet for global investors. This reduces the pool of investors to those that have the risk tolerance to place funds in that particular class of market, and demand a commensurate risk premium. The MSCI Frontier Market Index includes countries ranging from Romania and Kazakhstan to Tunisia, Oman and Bangladesh.
However, it is important to note that the risks evaluated in determining a country’s category are generally related to equity market practices, which do not directly translate to how risky or stable the overall economy is. For example, there are many countries in the MSCI Frontier Market Index that can boast investment-grade ratings from credit ratings agencies, meaning their economies are strong enough that evaluators do not think their sovereign debt is a risky investment.
Indeed, some frontier markets, such as Kuwait, Estonia and Lithuania, have credit ratings in the “A” category – better than some countries whose exchanges qualify for MSCI’s World Index of developed markets, such as Portugal, Spain and Italy.
Other countries are not included in the MSCI Emerging Markets or Frontier Markets indices, but are monitored with their own standalone index that uses the same emerging or frontier market methodological criteria concerning size and liquidity. Standalone indices under the frontier market category include Jamaica, Bulgaria, Zimbabwe and Palestine.
Argentina & Saudi Arabia
Both Argentina and Saudi Arabia were upgraded to emerging market status as the direct result of reformist governments working to open up their country’s financial markets to global investors and specialised products.
Argentina’s reclassification comes amid President Mauricio Macri’s efforts to bring the country back to a respected position among international markets after repaying funds for sovereign debt on which it defaulted in 2001 at the height of an economic crisis. Among other measures, his administration has removed foreign exchange restrictions and capital controls, eliminated cash reserves and monthly repatriation limits in the equity market, and abolished lock-up periods for investments. In addition, in September 2017 the stock market moved from a T+3 trading settlement cycle, in which trades of listed securities were settled in three days, to a T+2 cycle of two days. The shift benefits the exchange by bringing it in line with others around the world. However, Argentina’s economy remains vulnerable, as demonstrated by its “B” credit rating.
Saudi Arabia, meanwhile, is undergoing rapid reforms as part of its Vision 2030 economic plan to increase investment and reduce dependence on oil revenue. One of the most important recent changes for the stock market occurred in April 2018, when the country also migrated to a T+2 trading settlement cycle. Previously, Saudi Arabia employed same-day execution and settlement. Listed companies are also aligning their accounting practices with International Financial Reporting Standards, enabling their financial statements to be directly compared to companies in countries that employ the same regulatory system.
Furthermore, the Saudi Capital Market Authority has eased restrictions for foreign investors looking to enter the local financial arena.
In achieving emerging market status, Argentina and Saudi Arabia sent a message to the world about the calibre of their exchange operations. As Bassel Khatoun and Salah Shamma of Franklin Templeton Investments wrote on the company blog in April 2018, FTSE Russell’s classification of Saudi Arabia as an emerging market “sends a strong signal to investors that the country has made significant progress in opening up its capital markets, and has proved its levels of corporate governance and transparency”.
Matter of Prestige
Beyond technical frameworks and revised regulations, a classification upgrade can have a ripple effect across the entire economy and improve a country’s business reputation. “It has importance as a public relations and marketing concept,” Robert Abad, founder of US emerging market advisory firm EM+BRACE, told OBG. “In the old days, emerging economies were simply synonymous with ‘less developed’.” Speaking to Argentina’s history, he added, “About 100 years ago the country was a trading giant and the eighth-richest country in the world. Being labelled as a frontier market placed it in the same bucket as apparently third-tier countries. The emerging market classification raises Argentina’s status.”
This aligns with the local view of Federico Sidi, the Argentine equity portfolio manager at Compass Group, a Latin American advisory firm. “The government is pushing for this type of recognition as a kind of seal of quality or trademark,” Sidi told OBG. “It is not just financial markets – Argentina wants to join the OECD and use the hosting of the 2018 G20 summit to show the world how the country has bettered itself.” While agreeing that Argentina’s global visibility and reputation will likely improve, Matías Lara Mateos, investor relations officer at Bolsas y Mercados Argentinos (BYMA), the local stock exchange, added that the enhanced perception of the country could reduce national financial risk.
While positive changes in reputation are a welcome side effect, the most material result of an index upgrade is the amount of money a country’s capital markets can attract. Benchmarks hold considerable power in the global investment landscape: MSCI notes that 99 of the top-100 global investment managers were among its clients as of December 2017, and the firm estimates that its indices are the primary benchmark tools for more than 85% of all internationally focused fund assets.
In November 2017 MSCI calculated that roughly $12.4trn of assets under management were benchmarked to its equity indices, including $1.65trn to its Emerging Markets Index. Approximately 84% of those following the index are active managers, with the remaining 16% passive observers.
Before Argentina’s upgrade, JP Morgan estimated that $463bn worth of funds were passively tracking MSCI’s Emerging Markets Index. In April 2018 MSCI stated that Argentina would likely represent 0.6% of the index should it be reclassified, translating into approximately $2.78bn of passive inflows.
Active emerging market investors manage around $1.2trn, according to JP Morgan, which estimated their exposure to Argentina at 0.41% as of February 2018. Assuming these investors stay neutral on their positions now that Argentina is included in the Emerging Markets Index, the additional active inflows are expected to be around $2.7bn. In total, this aligns with the company’s forecast that Argentina will experience around $5.5bn of inflows to its stock market after reclassification.
Sidi told OBG that JP Morgan’s inflow estimates are among the highest he has seen, but it is nonetheless clear that global emerging market fund managers are likely to turn their eyes to Argentina. “The fact is that a lot of funds are unable to invest in frontier markets,” he said. “Our understanding is that hedge funds have taken advantage of the massive upside in Argentina since 2013, and that most of the largest long funds are here – but not in such a big way.” With daily trading volumes on the BYMA in the first quarter of 2018 averaging just $50m, more investor activity would have a huge impact on liquidity. “Being part of the emerging market environment again should see local market volumes pick up significantly,” Sidi added.
Average daily trading volumes are much higher in Saudi Arabia – around $1bn – as are estimates from analysts regarding future capital inflows. Saudi Arabia’s NCB Capital estimates that around $39bn will flow to the Saudi Stock Exchange (Tadawul) as a result of the MSCI upgrade, with the country set to have a weight of 2.6% in the index.
This figure compares to the $3.2bn of inflows that NCB Capital predicted in September 2017 in anticipation of the FTSE Russell reclassification in March 2018. Saudi Arabia’s inclusion in the FTSE Emerging Markets Index will be implemented in five stages between March and December 2019, and the country will comprise 2.7% of the index value. Some 99% of the $115bn of assets under management benchmarked against the FTSE Emerging Markets Index is passively managed, meaning the inflows are effectively guaranteed. “The promotion into FTSE Russell’s emerging market category marks a key milestone for Saudi Arabia, and rewards the depth and pace of reform that has taken place within the Kingdom’s capital markets in the last few years,” Jadwa Investment’s Al Turki told OBG. Both Saudi Arabia and Argentina will be included in the MSCI Emerging Markets Index beginning in mid-2019.
Saudi Arabia’s weight in the indices is likely to grow if national oil company Saudi Aramco executes what some analysts say could be the largest initial public offering (IPO) in history. London-based emerging market investment manager Ashmore estimated in April 2018 that the country’s weight could increase to nearly 5% in global indices, while FTSE Russell said the Aramco IPO would likely push it to 4.6%.
What these inflows mean for share prices is hard to predict. Where necessary, MSCI and FTSE Russell stagger the inclusion of individual countries by gradually increasing their weight in indices, as will be the case for Saudi Arabia in 2019.
However, while inflows from passive accounts are concentrated around the inclusion date, active managers tend to anticipate the change before it is implemented. Often this means that any market rally comes before the official inclusion.
For instance, Qatar’s index boasted implied returns of approximately 38% and the UAE index registered returns of around 78% in the 11 months between MSCI’s reclassification announcement in June 2013 and the two countries’ official inclusion on the index, compared to returns on the order of 12% for the MSCI Emerging Markets Index as whole.
This is not always sustainable. Pakistan’s stock market hit a record high after MSCI upgraded it from frontier to emerging in June 2017, but by the end of the year the KSE-100, which measures performance of the Pakistani exchange, posted negative returns in excess of 15% – or 20% in dollar terms – as inflows did not arrive as expected. With a weight of just 0.1% of the index, Pakistan is proving to be less attractive to large fund managers than other markets. “Pakistan is at risk of being left out of the financing race, as I do not believe that core global emerging market managers are looking at it closely,” Edward Evans, equities portfolio manager at Ashmore, told OBG.
While the numbers can be somewhat volatile surrounding a reclassification announcement, Al Turki believes that one of the main qualitative benefits of Saudi stocks being included in the MSCI index is the excepted steady improvement in the efficiency of company operations. He noted that profit margins in some local sectors are currently “propped up” by either a lack of competition or strong government support.
“Foreign investors taking up larger stakes in Saudi companies and holding management accountable for strategic decisions will promote improvements in the use of assets in generating sales and ultimately increase return on equity,” he told OBG. Improved internal processes will place Saudi companies in a better position to attract investment once the government decreases the support it lends to certain sectors, as is planned, he added.
Beyond the Benchmark
Although index upgrades bring many benefits to a country’s financial ecosystem, it is important to understand that indices do not tell the whole story about a capital market. Saudi Arabia is a special case, given that foreign investors have only been allowed to participate in the stock market since 2015, but exclusion from an index does not necessarily mean that a country or a particular exchange is unsophisticated.
Ashmore’s Evans said he does not place much importance on index inclusion when he looks at where to invest. He highlighted that many businesses in emerging markets are continuously looking to attract capital and expand – regardless of inclusion in indices – and many follow best practices that enable their rapid growth. “There is a wider, very attractive universe out there beyond the indices,” he told OBG. “Exclusively following an index provider means you are exposed to a very narrow representation of all emerging markets.”
These comments lead to a broader a question about the role of indices in emerging markets. Jan Dehn, head of research at Ashmore, noted that such markets represent 60% of global GDP, but just 20% of global finance. “Emerging economies need a huge amount of finance to update infrastructure,” he told OBG. “So why not start by trying to solve the index issue?” The problem, according to Dehn, is the lack of representation of most developing countries in indices. This applies to both equity and debt markets. MSCI’s Emerging Markets Index includes just 24 countries, and its Frontier Markets Index covers roughly the same number.
In debt markets, where governments and companies can fund investment at a lower cost than in stock markets, the lack of coverage by index providers is arguably more critical. Although most emerging market sovereign dollar bonds are included in JP Morgan’s Emerging Markets Bond Index, just 18 local currency markets are included in the bank’s indices.
With most developing countries’ governments relying far more on domestic than international debt markets to finance themselves, Dehn has argued that the provision of local bond market indices could be considered a “public good”. According to him, not only would it improve access to funding for these governments, but it would also reduce risk and inefficiencies within the financial system.
“As an institutional investor, it is in your interest to have access to as broad a spectrum of the market as possible,” he told OBG. “With more comprehensive indices, investors around the world would benefit from more diversification and increased investment opportunities.” Dehn suggested that organisations such as the IMF or the World Bank could provide more inclusive indices, and that this would benefit their aim of advancing economic and financial progress in developing markets.
In addition to index gaps, it should be highlighted that a particular classification is simply a reflection of how one private company decides to group countries for their investors’ information. As nations like Saudi Arabia and Argentina look to modernise their capital markets, they must remember that an MSCI upgrade is a signal of their efforts moving in the right direction, not the driver of change itself, no matter how much money may enter the country as a result. “MSCI including Argentina in its Emerging Markets Index is just one step in the development of the local market,” Lara Mateos told OBG. “There is a lot of work to do beyond MSCI’s assessment, with education a major priority.” Lara Mateos added that Argentina needs greater financial education so everyday citizens can learn how to invest and companies can gain knowledge of the benefits of capital market access. While an MSCI or FTSE Russell classification can indeed focus attention on capital markets domestically and internationally, the regulations implemented to secure the status are of much greater fundamental importance. Still, if an upgrade can play even a small role in increasing awareness of local financial markets, it is worth promoting. To that end, emerging markets are set to continue striving for recognition from index providers. With tighter monetary conditions, meeting the standards required is a way to ensure that international investors are aware of local offerings.
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