By Tim Batho, (chief strategist, index policy, Asia Pacific)
Our recent announcements regarding the conclusion of the first phase of China A Shares, and of the final tranche of Saudi Arabian stocks into our FTSE Global Equity Index Series (GEIS) matters because asset owners and managers allocate according to the classification, and investment flows into promoted countries are also impacted.
In a recent blog we explained how we differentiated between developed and emerging markets in our country classification processes. But we also differentiate, within our Equity Country Classification framework, between Secondary Emerging and Advanced Emerging status. Why we do divide the emerging market classification in this way?
The genesis of this two-band emerging market structure dates back almost 20 years, when the country and capitalization coverage of the FTSE global equity indexes were expanded with the incorporation of the Barings Emerging Market Index in 2000. This integration added 20 countries and extended coverage to 90% of global equity markets. At the time of this expansion, the opportunity was taken to classify the countries in the existing World Index into “Developed” and “Advanced Emerging” markets. The additional countries from the Barings index, not already in the World Index, were classified as “Secondary Emerging” markets. Their combination with the World Index was termed the All-World Index.
The expansion of the global indexes prompted FTSE to launch a client consultation in 2003. A structured framework for classifying markets was proposed, consistent with FTSE’s philosophy of rules‑based, objective indexes. As well as consideration of country per capita income, the proposal set out other guiding principles for market classification. The results supported the creation of the Equity Country Classification framework used today. It also confirmed that there was support within the advisory committees and with clients more broadly, for the two-tier emerging market structure.
Is the two-tier structure still relevant today?
The table below identifies the additional criteria that must be satisfied to gain promotion from Secondary to Advance Emerging and Advanced Emerging to Developed. As can been seen, half of the six additional criteria required to move between the two emerging categories relate to the “Market and Regulatory Environment” segment. In reality, these relate to the ease of access and protection available to international investors. The extra criteria focus on the speed/complexity of the registration process to participate in a market, the protection of shareholder rights, the breadth of the universe that is available for investment without overly restrictive foreign ownership limits and the ability to efficiently trade both stocks and the underlying currency, plus the existence of a Central Counterparty Clearing House for equities.
The above criteria are key differentiating factors between the two emerging categories that reflect an important advancement on the progress path to Developed status. Without the two-band emerging categorization, the visibility of progress would be much more difficult for index users to assess and the requirements for any advancement within the framework would be enormous, albeit they remain challenging. Markets seeking promotion would also have less clarity about the potential path to advancement.
The required criteria to move between Advanced Emerging and Developed focus far more on technical market features, such as the availability of stock lending, short selling and a developed derivative market. These criteria significantly contribute to the attraction of a more varied type of market participant, which in turn leads to the development of deeper and broader liquidity. Improving market liquidity and having the appropriate facilities established as market practice to do so, is usually the final stepping stone to Developed status. Obviously, this is a critical prerequisite given the additional assets that follow the Developed market indexes.
At first blush, it might seem that dividing emerging into two sections might add to confusion, but we have found that the approach illuminates the path along the process for all market participants.
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