If Korea Becomes a Developed Nation

Index providers put a lot of time and effort into deciding whether countries are classified as developed or emerging nations.

The choice, to an outsider, seems simple. The U.S. is a developed country, and China is emerging. But breaking that down into a rule-set is more of a challenge. Each of the major index providers looks at a different set of criteria to make its determination.

With billions of dollars tied to each market, these classification systems matter, and countries lobby index providers hard to convince them that they meet this or that criteria.

For ETF investors, the index provider that matters most in this regard is MSCI, which dominates the market for both developed and emerging market international ETFs. MSCI has an annual review process for evaluating economic development status based on economic development, size and liquidity requirements, and market accessibility criteria. It maintains watch lists of countries that are under consideration for status changes.

In the middle of 2010, Israel jumped from emerging to developed status in the MSCI system, as it finally was judged to fully meet MSCI’s criteria for developed markets. Based on a 2008 consultation report from MSCI, the country’s graduation was primarily held up by concerns about market accessibility, but currently, the only remaining issue of concern, MSCI says, is the Tel Aviv Stock Exchange’s settlement cycle, which is shorter than is normal for a developed market. The issue is considered a minor one and did not prevent the country’s promotion to developed status.

Among other things, the promotion pushed Israel out of the broadly followed MSCI Emerging Markets Index and into the pre-eminent benchmark for measuring developed international equity performance, the MSCI EAFE (Europe, Australasia and the Far East).

Investors always want to know what will happen to a country’s market when a graduation event takes place. Viewed from a static ETF-only lens, the answer is simple. On April 30, 2010, there was roughly $60 billion in ETF money invested in the MSCI Emerging Markets Index via the Vanguard Emerging Markets ETF (VWO) and the iShares MSCI Emerging Markets Index Fund (EEM). Israel had a 4 percent weight in the index, meaning the funds likely had in the area of $2.4 billion invested in Israeli equities at the time. When MSCI promoted Israel, those funds had to sell.

The next countries likely to graduate in the MSCI system may be bigger deals. In both 2009 and 2010, MSCI decided after careful review to leave both South Korea and Taiwan in the emerging markets index. They won’t be up for review again until June 2011. If chosen, they would make the switch in the middle of 2012. If that happens, MSCI would have to decide whether to make the transition over a period of time in a step process, or all at once.

Both countries meet many of the requirements MSCI has of developed nations. Korea satisfies the criteria in economic development, size and liquidity, but it fails on three levels: the lack of an offshore currency market for the Korean won; investor accessibility; and continued anti-competitive practices. With no active offshore currency market, investors need to exchange their money into won during Korean trading hours in order to trade. However, the limited trading hours means Korea’s market is mostly closed when Western markets are open. Meanwhile, a rigid identification system limits investor accessibility in the use of omnibus accounts. For instance, instead of Fidelity Investments having one account, it needs to set up separate accounts for each mutual fund that wants to trade in Korea, creating a very inefficient system. Finally, stock market data continues to be subject to contractual anti-competitive practices as a way to keep trades on the Korean market.

Taiwan also meets the economic development criteria, along with the size and liquidity requirements. However, market participants have said Taiwan’s overall market accessibility is comparable with that of Korea’s. MSCI said the “lack of full convertibility of the new Taiwan Dollar and restrictions associated with the Foreign Institutional Investors identification system were raised as areas where significant progress is still required.”

But if South Korea and Taiwan resolve these issues, the impact will be large.

For the full story go to IndexUniverse.com.

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