FORTY YEARS A few months ago, Antoine van Agtmael of the International Finance Corporation pitched the idea of ââa âthird world equity fundâ to skeptical fund managers, and the concept of emerging markets entered the investment global. The aim was to provide diverse exposure to fast growing countries outside of the rich world. Since then, emerging and developing countries have, on the whole, gained in economic and corporate weight. But the large disparities between them make it increasingly strange to group them together in one category. What might a new framework for investing outside the rich world look like?
In the early 1980s, emerging and developing countries accounted for around 25% of the GDP, according to IMF. Today, they represent around 40% and over 20% of the total global market capitalization. The market capitalization of MSCI the emerging markets index, as a proportion of the global gauge, has been multiplied by 13.
However, the economic situations of countries vary considerably. Consider, for example, the MSCI emerging markets index. In 1988, when the gauge was launched, the per capita income of the included countries ranged from $ 1,123 in Thailand to $ 7,598 in Greece. In 2019, the range was more than four times higher, going from $ 2,100 for India to $ 31,846 for South Korea. The fortunes of some economies, such as Brazil and Russia, are tied to the vagaries of commodity markets; those in East and South-East Asia, on the other hand, are supplied by manufacturing industry.
Existing definitions of emerging markets do not capture such complexity. Most people, including many investors, think of the category as related to income levels. But index providers are also considering whether trading in the markets is as smooth as it is in the rich world. Therefore, although South Korea and Taiwan are rich, their markets are not considered “developed”. The result is a very concentrated grouping: the two East Asian countries together represent 27% of the MSCI emerging markets index.
How then to think of exposing oneself to more than three quarters of the world population and two fifths of the world economy? A geographically organized framework hardly seems less arbitrary than the classification of emerging markets: the Turkish and Saudi markets, say, have little in common. Another approach would be to segment countries by income. But that too can have strange results. The low-income category, for example, would combine places that have not developed for decades with those that may soon take off. The Republic of Congo and Vietnam have similar levels of per capita income, but share few other economic qualities. Kuwait and Taiwan are equally wealthy overall, but their stock markets are very different. Income levels alone don’t say much about a country’s outlook.
Perhaps a more promising approach is to think of countries instead in terms of their growth models. This framework would apply to large familiar emerging economies, as well as more sophisticated âfrontierâ markets. Investors wishing to gain more exposure to major exporting powers might look not only to China, South Korea and Taiwan, but also to later adopters of the model, such as Bangladesh and Vietnam. These are still minnows compared to the market capitalization of incumbents of around $ 16 billion. But adding them makes sense, as they are already benefiting from rising Chinese wages and could expand into high-tech manufacturing.
A second category could include countries that rely more on service-led growth, with all the promises of healthy middle-class consumption. Here India and Indonesia are possible candidates; Kenya could be a border market worth investigating. And a third group could include commodity exporters, such as Brazil, Russia and South Africa. These have provided dismal returns over the past decade and have declined in proportion to emerging market indices. But climate change and the green transition could create new winners and losers, as some resources, such as metals from batteries, become sought after and others fall out of favor.
Such a taxonomy is far from perfect. Growth patterns can change over time, to begin with. Just think of China, which is looking to become more consumer-oriented. Many small countries have long hoped to increase their exports, but they are not disappointed by poor policy making. Yet the strategy of lumping a large part of the world’s population and production into one category is no longer useful. It’s time to experiment.
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This article appeared in the Finance & economics section of the print edition under the title “Brave new world”