What if Korea/Taiwan graduate?

Promotion of South Korea and Taiwan to developed market status will have a positive impact on India

The Asian markets were all abuzz last week with talk of the impending promotion by MSCI of South Korea and Taiwan to developed market status.

MSCI(Morgan Stanley Capital International) is a vendor of indices and benchmarks used to evaluate the relative performance of money managers.

MSCI publishes various benchmarks such as the Emerging Markets Free Index, MSCI World, MSCI U.S etc. Different benchmarks are used by money managers to evaluate their relative performance depending on their client mandate and investable universe.

Thus an emerging market fund would use the MSCI EMF(Emerging Markets Free) index as its benchmark, while a global fund would use the MSCI World index and a US only fund the MSCI U.S index to evaluate performance.

The MSCI World index is a developed markets index and does not include emerging markets, which are covered by the MSCI EMF index. The only Asian markets included in the world index are Australia/New Zealand/Singapore/Hong Kong.

It is rare and unusual for a fund manager to buy company stock in a country which is totally unrepresented in his/her benchmark. For example one would not expect an emerging markets fund using the MSCI EMF index as its benchmark to buy US equities.

Thus a step like the one rumoured above, which would effectively move Korea and Taiwan out of the Emerging Market benchmark into a developed market one(MSCI World/EAFE), is likely to cause significant money flows.

Emerging Market funds would be forced to sell out of these two countries as they would no longer be in their benchmark, and developed market investors would buy as these countries suddenly became a part of their benchmark and investable.

The quantum and direction of flows would depend on the number and size of funds using these respective benchmarks and the weight of the two countries in their old and new indices.

The only investors relatively unaffected would be the hedge funds, as they tend to be less driven by benchmarks (and their composition) in their strive for absolute returns. Their mandates anyway typically tend to be all encompassing and less restrictive.

All this speculation was fuelled by reports that FTSE (a competing vendor of indices) had decided to move these two markets into its classification of developed countries, and it was felt that MSCI was about to react similarly.

A Bloomberg story quoting the head of MSCI's Tokyo office as considering the upgrade of some emerging markets only added fuel to the fire.

This potential move was big news given the size of these two markets in the emerging markets universe, the swings in money flow it would precipitate and the impact it would have on the sectoral and regional composition of the emerging market index.

Currently, Korea and Taiwan are the largest(19.2 per cent) and third largest(12.5 per cent) markets in the EMF index with a combined weight of 31.7 per cent.

If they were to move out, South Africa would become the largest market with an enhanced weight of 19.1 per cent, followed by Brazil(12.4 per cent) and China(11.9 per cent).

Regionally Asia would no longer be dominant, falling from a current index weight of 54.8 per cent to 33.8 per cent. EMEA(Eastern Europe/Middle East/Africa) would become the dominant region with an index weight of 39.2 per cent, compared to 26.8 per cent currently.

Of course all these pro-forma numbers are based on certain assumptions, but give a reasonable idea of the likely changes in country and regional weights.

On a sector basis, the removal of these two countries would effectively wipe out the bulk of the emerging markets technology sector. The weight of semi-conductors and tech. hardware would drop from 15.8 per cent to 0.9 per cent.

Materials would remain the largest sector with its weight rising to nearly 20 per cent, energy would move to the second spot with a weight of 16 per cent.

The weight of cyclicals as a whole would drop in the index from 47.4 per cent currently to 35 per cent.(Emerging Markets tech. is perceived to be highly cyclical).

From a valuation perspective, removing these two countries would lower the current P/E of the EMF index from 15.8 to 14.6 and raise the ROE from 12.4 per cent to 13.8 per cent.(Source:CSFB).

In terms of money flows, a study done by Morgan Stanley using various assumptions on value of funds benchmarked to the respective indices and prospective developed market weights of Korea/Taiwan estimated a net outflow of about $ 2.7 billion for Korea, and a possible inflow of $ 15 billion for Taiwan.

The large disparity in flows is due to the assumption that the current free float discount for Taiwan will disappear as it makes the transition to a developed market. As this discount is removed, Taiwan will have a relatively higher representation in the new index.

From an Indian perspective much of the above will be positive. Firstly India will see a near 50 per cent rise in its weightage of the EMF index, jumping from the current 5.4 per cent to nearly 8 per cent, becoming the fifth largest market.

This sharp jump will undoubtedly trigger fresh flows and increased investor attention. Also India will effectively become the sole technology player in the Emerging Markets universe with its IT services sector dwarfing all other technology sub-sectors.

The wide breadth of economic sectors represented in India, and the quality and global competitiveness of Indian corporates will further stand out.

As to what are the chances of this move happening soon? I would argue that it is unwise to hold one's breath waiting for this to happen, even though both the countries are above the World Bank high-income country threshold.

Both also screen favourably on other inclusion criteria such as market liquidity and long-term credit ratings. However, MSCI country reclassifications tend to be long drawn out affairs and begin with an internal review process.

This is followed by consultation with investors and then finally a public announcement of an implementation date (usually 12 months later).

Also, Taiwan has yet to be classified as a pure Emerging Market by MSCI. The index provider continues to delay removing the discount factor applied to that country due to its perceived capital controls.

It seems unlikely that MSCI would upgrade Taiwan straight to developed country status without removing this discount first. Such a move would also in all probability encounter strong resistance from Emerging Market fund clients of MSCI.

The dropping of these two big markets could seriously hurt the future growth prospects and business economics of the emerging market asset class. Given its economic impact, at a minimum such a significant change is unlikely without months of debate and consultation.

All the fuss caused by these rumoured changes is likely to quickly die down. While nothing is likely to change in the near term, all the commotion at least forced everyone to look at the examples of Greece and Portugal, the only two countries (till date) to have made this transition.

Portugal was relatively cheap when the decision was taken to upgrade its status and it outperformed continuously from the date of announcement through implementation.

Greece was relatively expensive and under performed continuously from the announcement of its promotion through implementation.