Classification of Markets in the
MSCI Equity Indices | January 2008

Discussion Paper on the Classification of Markets in the MSCI Equity
Indices
Twenty years ago, MSCI launched the MSCI Emerging Markets Indices as the firstcomprehensive and consistent investable benchmarks for this component of global equity
markets. During the lifetime of the indices, the Emerging Markets’ economies have grown at a
rapid pace and their equity markets have become more accessible and more efficient. Emerging
Markets have brought significant diversification and enhanced returns opportunities to investorseven as correlations with Developed Markets have increased over time. As an asset class now
representing more than 11% of the MSCI ACWI Index, Emerging Markets have become more
central in asset allocation and mandate attribution decisions while the investment strategies atwork in these markets are more diverse and increasingly sophisticated. It is with this backgroundthat MSCI Barra is presenting this discussion paper with the intent to engage the investmentcommunity in a dialogue about some of the criteria underpinning the classification of markets in
the MSCI index series.
This paper expresses views and contains questions intended to foster a discussion with market
participants. It does not reflect any proposal for change to the indices. Decisions, if any, affecting
constituents of the MSCI Indices would be announced separately following a specific consultation
based on a proposal. Implementation of any significant changes would be made after providing
ample notice.
Given recent trends, MSCI Barra believes that it is now a good opportunity to have an active
discussion on some classification criteria. Among these trends, the following are worthhighlighting:•Some Emerging Markets like Korea and Israel, while not fully meeting all standards thatcharacterize Developed Markets, have achieved significant advancements in their structure
and openness to international investors.

•

At the same time, smaller and less accessible markets have increasingly come to theattention of investors, and MSCI Barra has launched the MSCI Frontier Market Indices,
including the five GCC countries open to foreign investors, to address the needs of investors
willing to consider these new investment opportunities.

•

Markets like China A-shares and Saudi Arabia, while today essentially domestic markets,
have also experienced considerable growth. If, in the future, these markets open themselves
significantly to international investors, a meaningful broadening of the opportunity set for
global investors will result.

In a classification framework spanning the spectrum of market types, from pre-Frontier, toFrontier, to Emerging and then to Developed Market, a new market accessible to international
investors would logically start as a Frontier Market and evolve over time, if and when warranted,
to Emerging Market status first and then to Developed Market status. In following this path, amarket would need to comply with increasingly stricter standards in terms of:• Market accessibility (openness to foreign investment, investability, and robustness andefficiency of the operational framework).
• Company and security minimum size and liquidity, as well as minimum number of companies
and aggregate size of eligible securities.

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Classification of Markets in the MSCI Equity
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Sustainable characteristics of advanced economies and levels of geo-political risk
comparable to other existing Developed Markets, for achieving Developed Market status.

While there may be a broad consensus in the investment community with respect to mostclassification requirements, MSCI Barra believes that the following factors and considerations
may deserve further discussion:
•
•
•
•
•

The requirement that a country achieve the full liberalization of its foreign exchange markets
in order to be considered for Developed Market status
The requirement that no major geo-political risk exists for a country for it to be considered forDeveloped Market status; and the related question of how to assess geo-political risk
The role of capital controls, in particular of prolonged restrictions on repatriation and/or
inflows, including cash reserve requirements, in determining the difference between Frontierand Emerging Markets
The role and impact, throughout the classification framework, of increasing minimum size andliquidity eligibility requirements
The types of restrictions imposed on foreign investors by regulators and their impact on theway the opportunity set can be reflected in the indices

These five points are discussed below
1. Liberalization of the Foreign Exchange Market
In order for a market to attain Developed Market status, MSCI Barra views the existence of a fully
convertible currency, including in offshore markets, as an important requirement. This condition
for seamless accessibility and fully competitive, cost effective, foreign exchange services is met
by all current Developed Markets.
At this moment, only a limited number of Emerging Markets, mostly in Europe, and including
Israel, have a fully convertible currency. All Emerging Market Asian currencies, including thosefrom Korea and Taiwan, are not fully convertible. Korea has announced a plan for theliberalization of its foreign exchange market and has started to implement a series of steps in that
direction. Most recently, the Korean authorities have eliminated the “real demand principle”. This
principle made the purchase of local currency dependent upon proof that a securities transaction
had actually taken place, causing inefficiencies and limited competition in foreign exchange
services onshore. While this and other such liberalizations are very positive developments, theireffects are yet to be fully assessed by market participants. For now the Korean authorities havenot expressed any intention to permit the development of an offshore market for their currency.
Some investors may see MSCI Barra’s Developed Market requirement for a fully liberalized
foreign exchange market as excessive. MSCI Barra would like to engage investors to discuss theimportance and the extent of this requirement. Including a country without a fully liberalized
foreign exchange market in Developed Markets would result in a de-facto lowering of thestandard for Developed Markets. Is that desirable? Is that a problem?
2. Major Geo-Political Risk
There is a general consensus that the existence of major political risks is a characteristic of
Emerging Markets. One type of political risk is geo-political risk. Geo-political risk is linked to theexistence of threats to the sovereignty of a country and to the integrity of its institutions, its people
and their assets.

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Classification of Markets in the MSCI Equity
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MSCI Barra has heretofore refrained from considering countries with high geo-political risk forinclusion in its Developed Markets Indices. Three of the more advanced Emerging Markets arecharacterized by important geo-political risks: South Korea, due to the North Korean threat,
Taiwan due to China’s claims and Israel due to the Palestinian issue. While over time investors
have expressed concerns about those risks in the context of Developed Markets, more recently
some investors have conveyed the opinion that the Korean risk is now more acceptable.
With respect to this factor also, there are investors who believe that these considerations shouldplay no role in MSCI Barra’s Market Classification, and there are those who have a very different
assessment of these risks. MSCI Barra would like investors to put forward arguments in thisdebate. Including a country in Developed Markets with a high level of geo-political risk would
result in a de-facto lowering of the standard for Developed Markets. Is that desirable? Is that aproblem?
3. Restrictions on Funds Repatriation and/or Inflows
Historically, various forms of capital controls have existed in several Emerging Markets at somepoint in time, often as temporary restrictions in response to a particular financial crisis. However,some markets have had prolonged periods of inaccessibility. With the creation of a FrontierMarkets category, there is a case for setting a higher standard for Emerging Markets andclassifying those countries with systemic poor accessibility as Frontier Markets. Should this, inparticular, apply to Argentina and Colombia, both of which, for protracted periods, havemaintained restrictions and penalties to discourage inflows and outflows into/from their equity
markets? Would there also be a case to consider reclassifying markets that have a history ofusing temporary restrictions, like Thailand, to Frontier Markets?
If a distinction needs to be made, how long should temporary accessibility restrictions last before
considering a change in status from Emerging Market to Frontier Market? Can there be an
explicit timeframe that holds for any phase in a market cycle?
4. Increasing Size and Liquidity Requirements
The MSCI Global Investable Markets Indices (GIMI) methodology has introduced different
eligibility criteria related to size and liquidity, to account for the fact that investors have different
expectations for market categories with very different characteristics. There are higher
requirements for Developed Markets than for Emerging Markets, and Frontier Markets have evenlower requirements. These differences are particularly important for the Standard Indices (Large+ Mid Cap companies) which intend to represent, in a cost-efficient way, the core holdings ofinvestors.
At this point in time there are several Frontier Markets where the constituents of the MSCIStandard Index would pass the minimum size and investability requirements for Emerging
Markets, namely, the United Arab Emirates, Kuwait and Qatar. Provided that their operationalframeworks become robust and efficient, it is reasonable to expect that these markets should
transition to the Emerging Markets Index.
By contrast, most securities in Jordan fail the minimum size and investability requirements for
Emerging Markets. For continuity purposes, the GIMI methodology ensures that a country index
currently classified as an Emerging Market would have a minimum of three constituents in theStandard Index, even if one or more of the three securities do not fulfill minimum size andinvestability requirements. Would it be appropriate to modify the GIMI methodology, such that if aStandard Index for a market did not have at least three constituents that met the minimum
requirement in a twelve-month period, the market should no longer qualify for Emerging Market
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Classification of Markets in the MSCI Equity
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status? In such a scenario, Jordan would be considered for reclassification to the FrontierMarkets, where the lower requirements would result in a more balanced index.
There could also be a case for imposing aggregate materiality thresholds at the country level, for
the Standard Index. Several emerging markets are small and, as a consequence, are overlookedby many emerging markets investors. Should markets such as Pakistan or Morocco be more
appropriately classified in Frontier Markets based on materiality thresholds?
5. Dealing with investment restrictions and constraints in markets that are openingup
Today, two important markets remain largely closed to foreign investors: Saudi Arabia and China
A. However, some investors are in a position to get exposure to these markets. A number ofqualified institutional investors (QFII) are accessing the China A market through their approved
investment quota. Other investors are getting exposure to A shares indirectly throughParticipatory Notes or other synthetic securities. In Saudi Arabia, foreign investors are able to get
exposure to the domestic market through dedicated mutual funds.
The gradual opening of these markets has started, and some evolutionary paths could beenvisioned.
Historically countries have followed several paths to open up their markets to global investors.
The most common ways are a) defining Foreign Ownerships Limits (FOLs) at the security level
which would be progressively increased, b) introducing separate share classes reserved toforeign investors, often with reduced voting power and c) establishing quota systems set at each
investor level and also at the aggregate level for all foreign investors.
FOLs and separate share classes aim to limit the ability of foreign investors to exercise somedegree of control on domestic companies. The objective of quota systems is to closely control
and limit the foreign capital flows into and from the country. Many countries have used thesemeasures individually or in combination.
The different paths to opening a market to foreign investors have different consequences in termsof speed and ease of reflection in a global index.
Foreign ownership limits are currently taken into account in the free-float available to foreign
investors, which is used to calculate the weight of a security in the index. This very simple
treatment works as long as the maximum ownership limit is not reached by foreign investors.
After that point, this simple treatment may not reflect the illiquidity experienced by prospective
international investors and the security should logically be deleted from the index unless there aremechanisms in place for foreigners to trade amongst themselves at a different price.
Separate share classes that foreign investors can buy with no limit are technically the easiest toreflect in an index. But they are disliked by investors because their greatly reduced voting rights
are seen as poor governance and mistreatment of minority investors.
Finally restrictions implemented through quota systems are the most problematic to reflect in a
global equity index. These systems create important differences in the treatment between
investors as authorities exercise discretion on the decision to grant a quota to each applicant, on
the timing of the grant and on the size of the quota. In addition, once a quota is approved, thecorresponding amounts generally need to be fully remitted within certain timeframes failing which
the unused quota is cancelled. Given the imperative for an index to act in fairness to all investors,
the recognition of the markets that choose this route can only take place with significant delays
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Classification of Markets in the MSCI Equity
Indices | January 2008
and at reduced weights, through the use of Limited Investability Factors (LIFs), as was the casewith Taiwan in the MSCI Emerging Markets Indices from September 1996 to May 2005.
Today, the QFII and quota process for accessing the China A market is still too restrictive toconsider a partial inclusion of China A Shares in the MSCI Emerging Markets Index. However,with the creation of the MSCI Frontier Markets Indices, would there be a case for considering apartial inclusion of China A and Saudi Arabia shares into the Frontier Market Index? And if this ispremature today, what would need to happen in the accessibility to these markets for some
representation in the Frontier Markets to be considered?
----------------------------------MSCI Barra will proactively seek views from investors over the next few months and welcomes
feedback from all market participants on the topics raised and views expressed in this discussion
paper. Market participants are invited to contact MSCI Barra client service to provide feedback.
MSCI Barra intends to share its conclusions from the discussions with the investment community
by June 2008.
Please note that this is a discussion document, not a proposal for changes. Other considerations,in addition to those highlighted in this document may significantly impact the assessment ofmarkets. Decisions, if any, affecting constituents of the MSCI Indices would be announced
separately and would follow a specific consultation based on a publicly available proposal.
Significant index changes, if any, following the specific consultation would be implemented with
ample lead-time.
----------------------------------APPENDIX: MARKET CLASSIFICATION FRAMEWORK
Criteria

Frontier

Emerging

Developed

A Market Accesibility
A.1
Openness to foreign ownership
A.2
Restrictions to Inflow / Outflow of Funds
A.3
Efficiency of operational framework
A.4
Full convertibility of currency

At least someMay exist
ModestNo requirement

Significant
MinimalGood and tested
No requirement

Very highNone
Very HighYes

B Size and Liquidity Requirements fo Standard Index
B.1
Company size (full) *B.2
Security size (float) *B.3
Security liquidity **B.4
Minimum nb of companies meeting criteria

USD 521 mm
USD 77 mm
2.5% ATVR2

USD 1042 mm
USD 521 mm
15% ATVR3

USD 2048 mm
USD 1042 mm
20% ATVR
5

C Economic Developemnt
C.1
High Income Country
C.2
Sustainability of Development

No requirement
No requirement

No requirement
No requirement

Yes
Yes

D Other
D.1

No requirement

No requirement

Yes

Absence of Major Geo-Political Risk

* Minimum in use for the November 2007 Semi-Annual Index Reviews** ATVR - Annualized Traded Value Ratio

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Classification of Markets in the MSCI Equity
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Classification of Markets in the MSCI Equity
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About MSCI Barra
MSCI Barra is a leading provider of investment decision support tools to investment institutions worldwide. MSCI Barra
products include indices and portfolio analytics for use in managing equity, fixed income and multi-asset class portfolios.
The company’s flagship products are the MSCI International Equity Indices, which are estimated to have over USD 3
trillion benchmarked to them, and the Barra risk models and portfolio analytics, which cover 56 equity and 46 fixed income
markets. MSCI Barra is headquartered in New York, with research and commercial offices around the world. Morgan
Stanley, a global financial services firm, is the majority shareholder of MSCI Barra.

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