IT is one of the most powerful definitions in the world and accounts for investment of more than $10tn. But with developing markets overtaking developed ones in some areas the term has become obsolete, say critics.

Now, commentators say, it is the world’s mental map that is in dire need of an overhaul, particularly when it comes to the practice of categorising countries as ‘emerging’ or ‘developed’ markets.

The current economic hierarchy, which places emerging nations at the periphery and developed markets at the core of world affairs, no longer accurately describes a world in which EM countries contribute a bigger share to global gross domestic product than their developed counterparts, when measured by purchasing power parity. Nor does the capacious category, which lumps together countries of such diverse economic strengths as China and the Czech Republic, serve to illuminate crucially different realities between these nations.

“The EM term has outgrown its usefulness,” says Michael Power, strategist at Investec, a fund management company. “The term today embraces big and small, developed and under-developed, industrialised and agrarian, manufacturing and commodity-based, rich and poor, deficit runners and surplus runners, and I could go on,” he adds.

At issue are not merely the niceties of symmetry and order. Emerging markets is one of the most powerful definitions in the world, with an estimated $10.3tn invested in emerging financial markets via an alphabet soup of equity and bond indices. But these indices embrace such a collection of incongruous assets, that they misdirect investors and potentially reduce returns to pension funds, insurance companies and other financial institutions.

The term also forms one of the organising principles for global databases and an analytical starting point for those seeking insights into economic, environmental, social and other trends that shape the world. But this, commentators say, generates flawed perceptions and fuzzy arguments that impact on the efficiency of global governance.

“As an asset class, EM equities are nearly finished,” says John Paul Smith at Ecstrat, an investment consultancy. “The old paradigm is dead.”

Already, some commentators are proposing alternatives to the definition, seeking to identify ordering principles and shared dynamics among clusters of developing countries. This, they hope, will allow institutions, companies and multilateral organisations to assess more accurately the balance of risk and opportunity in large parts of the world.

What’s in a name? At its inception, ‘emerging market’ was not designed as a definition with specific criteria. Antoine van Agtmael, then an economist at the International Financial Corporation, coined it as a marketing catchphrase in the 1980s.

The attraction was clear: it sounded aspirational. Countries previously known by monikers such as ‘less developed’ or ‘third world’ were suddenly imbued with the promise that they might be on a journey towards something better.

Since the 1980s, the stunning success of the term has spawned several attempts to nail down a set of commonly recognised characteristics — with the unintended consequence that different organisations such as the IMF, the UN and financial index providers such as MSCI, JPMorgan and FTSE use a clutter of conflicting criteria to categorise emerging markets.

Adding to the confusion, the term is sometimes used to describe equity, bond or currency markets in developing countries and sometimes to describe the countries themselves. Different criteria make a world of difference. The MSCI equity index identifies 23 emerging markets countries and puts 28 into a ‘frontier emerging markets’ category. The IMF, by contrast, defines 152 ‘emerging and developing economies’.

Even accepting prevailing classifications, it is often unclear why one country has been awarded emerging status while another merits a developed tag. Chile has a bigger economy, a bigger population, less debt and lower unemployment than Portugal but is classed as emerging, whereas the European nation remains part of the developed world. Similarly, on a per-capita income basis, Qatar, Saudi Arabia and South Korea are wealthier than several developed countries, but are still consigned to the emerging camp.

Such judgments often depend on the classifier. Providers of financial indices look at issues such as the freedom with which international investors can access the stocks and bonds of a particular country.

Others such as the IMF consider questions about the diversity of a country’s economy, in terms of how many products they import and export. Increasingly, the sense that emerging nations take their lead in global affairs from the so-called developed world is also under examination. In some senses, emerging economies already wield power. When calculated by purchasing power parity, which takes account of exchange rate changes, developed countries account for only 39pc of global GDP, down from 54pc in 2004.

Developed markets are also weaker, in aggregate, when it comes to the size of their foreign exchange reserves, the huge stashes of money that accumulate when a country notches up trade surpluses and attracts foreign direct investment. Developed markets hold $3.97tn, compared with $7.52tn for developing countries, according to IMF data. This leads to the curious situation in which emerging nations, which need to invest their reserves in large liquid debt markets, have ended up bankrolling years of deficit-financed excess in large developed countries. China, for instance, was the biggest foreign buyer of US Treasury debt for six years until early 2015.

But aside from the various ways in which the EM tail appears to be wagging the developed dog, the broad inclusion of scores of countries glosses over crucial differences between emerging nations, misleading observers to construe equivalence where none exists.

Sree Ramaswamy, senior fellow at McKinsey Global Institute, says that key determinants of a country’s economic dynamism and resilience often come down to “economic structure, industry dynamics, corporate landscape, and role of government or social and political make-up”.

“When it comes to these indicators, the differences between emerging markets outweigh their similarities,” Mr Ramaswamy argues.

“For instance, capital investment makes up 20pc of GDP in Mexico, but 45pc in China. Household consumption makes up 50pc of GDP in South Korea but 70pc in Turkey,” he adds. “The populations of China and India are similar in size but their demographic trends are very different. So is the corporate landscape; 60pc of Latin America’s corporate revenue is held by family controlled firms but in India it is 50pc and in China 30pc.”

China breaks the mould :To many, the problem of how to classify China highlights the emerging market dilemma. In PPP terms, China is already the world’s largest economy and yet it is still classified as emerging. The country has a literacy rate of 96pc, more high-speed rail track than all other countries combined and more college students than any other country.

Its near $8tn stock market is the world’s second largest after the US and its $5.5tn domestic bond market ranks third in the world after those of the US and Japan. Nevertheless, its domestic equities — not counting those listed in Hong Kong — and its bonds feature only marginally in the MSCI EM Index and JPMorgan EMBI+, the world’s leading equity and bond indices.

Inducting even a mere slice of the huge Chinese stock and bond markets into emerging market indices would create a financial earthquake, effectively forcing fund managers with ambitions to match an index’s performance into loading up on Chinese assets.

Peter Marber, fund manager at Loomis Sayles, echoes a widely held view that China’s size may break the emerging market mould.

Published in Dawn, Economic & Business, August 10th, 2015

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