Emerging markets have been one of the fastest growing asset classes in recent decades. The first major bond index, JP Morgan’s EMBI+, included government bonds from 14 countries, valued at $100bn. Today, various indices include issuers from 65 countries and cover assets valued at more than $2.6tn. MSCI's EM equity index was launched in 1988, starting with 10 countries. It now includes the largest companies from 23 countries, with around $1.6tn benchmarked to the index.
This mostly reflected the rapid growth of the emerging economies. They expanded by some 5% per year on average since 1990, while developed markets grew by roughly 2% per year. The EMs generated 58% of global economic activity in 2016 (adjusted for the purchasing power of their currencies). We believe that this share is set to increase further as EM growth outperformance continues.
Thanks to sustained growth, several emerging markets have effectively ‘emerged’ and their per capita income levels are comparable to those of some developed economies. But despite the rising role of the EMs in the global economy and the expansion of their markets, maps of the world financial system continue to marginalise these economies.
Rising income levels are not the only reason why the practice of labelling economies as either ‘developed’ or ‘emerging’ is reaching its limits.
The term ‘emerging markets’ is being applied to an increasingly diverse group of countries, stretching from the Czech Republic and South Korea to Nigeria and Vietnam. The list includes manufacturing economies with robust trade surpluses to commodity exporters with perennial financing needs. Because of this diversification, individual emerging markets and their assets respond to macroeconomic events very differently. The effects of the recent decline – and subsequent recovery – in commodity prices and changes in the outlook for the US federal funds rate are two noteworthy examples.
At the other extreme, some emerging market equity indices are very selective and include only the largest emerging market companies. These indices are heavily skewed towards commodity producers and exclude many medium-sized manufacturing and financial companies. This makes these equity indices strongly aligned with the commodity cycle, making them less representative of the economic cycle in manufacturing-oriented emerging markets.
Then there is China, which by some measures is already the largest economy in the world. Further growth in India and other large EMs will only add to the distortion generated by a restrictive definition in the future.
There is no clear definition of the term ‘emerging market’ and, to complicate matters further, it is used interchangeably to refer either to the whole economies or the financial markets of these economies.
The earliest classification defined emerging markets by exclusion. They were simply the countries that were neither the most developed nor the very lowest on the income scale. This definition is becoming quickly outdated. Some emerging markets have crossed the official (if arbitrary) threshold of the high-income grouping, and formerly low income countries are now gaining middle income status.
Then there is the definition of ‘capital importers’. The traditional understanding is that emerging markets were importing capital from developed economies to finance growth. This division is becoming old-fashioned as well. Emerging markets are becoming net creditors to developed economies, in large part due to the former’s accumulation of substantial international reserves, while EMs increasingly borrow from their peers, especially China and economies with sovereign wealth funds.
Emerging markets are also defined by judging their quality of governance and political risks. One of the definitions singles out EMs as those countries where, for financial assets, politics matters at least as much as economics does. But this definition relies on the assumption that the political systems of developed economies guarantee continuity. This is, at best, an optimistic assumption.
There are several ways countries can be regrouped. In addition to classifying countries by income, they could also be divided into manufacturers or commodity exporters, and those with current account deficits or surpluses, or low and high external debt. This would introduce an important distinction lacking in contemporary indices and would also allow for the inclusion of manufacturing and service-oriented companies from smaller emerging markets in equity indices.
Another method would be to group economies by similarities such as production and export structure, productivity, income, or credit rating. Such groupings would be more relevant, but would generate more country ‘clusters’ than those used today. This could be useful for investors following bottom-up or factor-based investment strategies, but would be difficult to implement in top-down approaches and to gain broad emerging market exposure. Indices based on smaller groupings would also be more volatile and provide less diversification.
Another approach is to rank countries and their financial markets using various quantitative and qualitative scores. Such a ranking will likely create a mapping broadly similar to that of the current emerging against developed market division, but would also reward smaller emerging economies with high quality policy-making and good liquidity. This method would likewise ‘penalise’ developed markets with worse policies and illiquid financial markets.
Despite their shortcomings, country groupings remain worthwhile tools. Many emerging economies still have smaller, less liquid financial markets in which foreign investors play a disproportionately large role. That makes these markets inherently more sensitive to the global rate cycle and investor sentiment. Many are small, open economies, with lower savings or fiscal space to smooth the growth cycle. This again distinguishes emerging markets from their more developed counterparts.
Most importantly, several emerging economies are still growing significantly faster than developed markets. Any group of assets with strong, distinguishing characteristics will inevitably be pooled into the same category or require an index to facilitate trading, diversification, and performance assessment. This is all the more true when interest in passive investment strategies is increasing. So while the definition of an ‘emerging market’ needs to be rewritten, the label is unlikely to disappear anytime soon.