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Why advanced economies such as South Korea are classed as emerging markets

Some investors might be surprised to find countries such as South Korea and Taiwan classed as emerging markets. There’s usually a good reason explains Pendal’s JAMES SYME

SOUTH Korea is one of the few countries in the world to develop its own supersonic jet fighter.

It’s a stable and mature democracy — and home to some world-leading technology companies.

So some investors might be surprised to find it’s classed as an emerging market, along with Taiwan and  wealthy Gulf countries such as Saudi Arabia and the United Arab Emirates.

What is an emerging market? Who decides the definition of emerging equity markets?

It’s an enduring controversy. Some countries at the more advanced end of the emerging markets (EM) spectrum could arguably be classified as developed markets.

It’s useful for investors to understand how countries are classified as emerging markets as opposed to frontier (or pre-emerging markets) and developed markets.

The origin of emerging markets

The term “emerging markets” dates back 40 years.

The International Finance Corporation (an arm of the World Bank) first began tracking stockmarket returns in 10 developing countries such as Argentina, Brazil and India in 1980.

The IFC came up with “emerging markets” as a way of describing these countries after rejecting dated terms such as “third world”.

The IFC based its definition on economic development, as measured by Gross National Product per capita (the annual value of a country’s goods and services divided by its population).

These days the definition used by the largest index provider, MSCI [PDF], is based around economic development, market size, liquidity and accessibility.

James Syme, Paul Wimborne and Ada Chan (l-r) … fund managers for Pendal Global Emerging Markets Opportunities fund

Under MSCI’s methodology four wealthy Gulf economies — Saudi Arabia, the United Arab Emirates, Kuwait and Qatar — are emerging markets, as are the highly successful economies of South Korea and Taiwan.

The case for South Korea

The question is often asked: is South Korea really an emerging market?

Events in the Korean domestic bond market since the end of September show why it probably still is.

The full series of events are too long to go into here.

But in short, a newly-elected provincial governor decided — for political rather than economic reasons — to push the local developer of a Legoland Korea theme park into bankruptcy and to renege on a government guarantee of the development company’s bonds.

The effect on domestic bonds was rapid and serious.

New issuance by local government development and housing companies proved impossible through October. Some major borrowers with investment grade credit ratings were unable to place bonds.

The bonds that the development and housing companies issue are called Project Finance Asset-Backed Commercial Paper (PF-ABCP).

They are the main funding source for Korea’s private-sector property developers, who saw their bond yields spike and began scaling back finance for new projects. In what very much looks like contagion, a mid-size life insurer delayed exercising a call option on some of its perpetual bonds.

Find out about

Pendal Global Emerging Markets Opportunities Fund

This was the first time this had happened since the financial crisis in 2009.

Despite the specific cause, this has come at a time of rising global interest rates and bond yields, a stronger US dollar, and a slowing Korean economy.

The conditions were in place for financial stress, but the combination of volatile politics and weak institutions acted as a trigger.

Dramatic move

The overall effect has been a dramatic move in the whole Korean commercial paper market.

Three-month Korean commercial paper typically has yields 0.25-0.5% higher than policy interest rates, but the gap at the end of November had reached 2.3% and still looked to be increasing.

So, despite generally tightening monetary policy through higher interest rates this year, Korean authorities have had to engineer a repurchase program to stabilise the market.

At the time of writing, this was KRW 2.8trn (USD 2.1bn) — but its size and scope have been steadily increased and more may well be required.

Ultimately, the creditworthiness of these instruments has not changed.

This is a shock to confidence — a market panic in the style of the nineteenth century.

The Bank of Korea and the Ministry of Finance are responding in the right way and they have the monetary firepower to settle the market at some point.

But there must be some resulting drag on Korean GDP growth and corporate earnings.

And this is why South Korea remains an emerging market.

Long-term excess returns

The long-term excess returns of emerging market equities over developed market equities compensates investors for the extra risk and volatility of emerging markets.

That risk can come in many forms. But it definitely includes a single provincial politician pushing the local Legoland into default and blowing up the entire domestic commercial paper market.

About Pendal Global Emerging Markets Opportunities Fund

James Syme, Paul Wimborne and Ada Chan are co-managers of Pendal’s Global Emerging Markets Opportunities Fund.

The fund aims to add value through a combination of country allocation and individual stock selection.

The country allocation process is based on analysis of a country’s economic growth, monetary policy, market liquidity, currency, governance/politics and equity market valuation.

The stock selection process focuses on buying quality growth stocks at attractive valuations.

Find out more about Pendal Global Emerging Markets Opportunities Fund here
Pendal is an independent, global investment management business focused on delivering superior investment returns for our clients through active management.

Contact a Pendal key account manager here

This information has been prepared by Pendal Fund Services Limited (PFSL) ABN 13 161 249 332, AFSL No 431426 and is current as at December 12, 2022. PFSL is the responsible entity and issuer of units in the Pendal Global Emerging Markets Opportunities Fund (Fund) ARSN: 159 605 811. A product disclosure statement (PDS) is available for the Fund and can be obtained by calling 1300 346 821 or visiting www.pendalgroup.com. The Target Market Determination (TMD) for the Fund is available at www.pendalgroup.com/ddo. You should obtain and consider the PDS and the TMD before deciding whether to acquire, continue to hold or dispose of units in the Fund. An investment in the Fund or any of the funds referred to in this web page is subject to investment risk, including possible delays in repayment of withdrawal proceeds and loss of income and principal invested. This information is for general purposes only, should not be considered as a comprehensive statement on any matter and should not be relied upon as such. It has been prepared without taking into account any recipient’s personal objectives, financial situation or needs. Because of this, recipients should, before acting on this information, consider its appropriateness having regard to their individual objectives, financial situation and needs. This information is not to be regarded as a securities recommendation. The information may contain material provided by third parties, is given in good faith and has been derived from sources believed to be accurate as at its issue date. While such material is published with necessary permission, and while all reasonable care has been taken to ensure that the information is complete and correct, to the maximum extent permitted by law neither PFSL nor any company in the Pendal group accepts any responsibility or liability for the accuracy or completeness of this information. Performance figures are calculated in accordance with the Financial Services Council (FSC) standards. Performance data (post-fee) assumes reinvestment of distributions and is calculated using exit prices, net of management costs. Performance data (pre-fee) is calculated by adding back management costs to the post-fee performance. Past performance is not a reliable indicator of future performance. Any projections are predictive only and should not be relied upon when making an investment decision or recommendation. Whilst we have used every effort to ensure that the assumptions on which the projections are based are reasonable, the projections may be based on incorrect assumptions or may not take into account known or unknown risks and uncertainties. The actual results may differ materially from these projections. For more information, please call Customer Relations on 1300 346 821 8am to 6pm (Sydney time) or visit our website www.pendalgroup.com

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