A broader look at EM countries reveals that China is not anomalous – in fact, disparities between economic and market size exist for many EM countries. China’s new title as the world’s largest economy and the November launch of its groundbreaking stock connect program has made for a noteworthy growth story. But China is not the only large EM economy to have recently made progress toward growing both its equity markets and economic footprint. For example, India and Indonesia both held national elections in 2014, the results of which delivered the promise of economic reform.
Largely as a result of these developments, China, India and Indonesia all delivered positive country performance in 2014, effectively increasing the size of their equity markets and corresponding share of market cap weighted indexes. But when considering economic size (as measured by GDP), all three of these countries are still underrepresented in global market cap weighted indexes relative to developed countries.
The chart below illustrates how choice of yardstick to measure a country’s size can yield significantly different results. When comparing the market cap weighted FTSE All-World Index to the FTSE All-World GDP Weighted Index, the weights of these three EM countries differ materially.
Source: FTSE as of January 31, 2015
The reverse is true for some of the largest developed countries. For example, the U.S. comprises over half of the FTSE All-World Index but represents only 22% of the FTSE All-World GDP Weighted Index. Similarly, the UK and Switzerland are assigned significantly larger weightings in the market cap weighted FTSE All-World Index.
Source: FTSE as of January 31, 2015
These differences can perhaps be better understood by examining the relationship between each country’s market size (measured by market cap) and economic size (measured by GDP). In many developed countries, the equity market has played a significant role in providing a source of finance for economic activity and these countries tend to have a higher ratio of market capitalization to GDP.
Conversely, market cap/GDP ratios are generally lower for emerging economies whose local companies rely on other sources of finance like bank loans and retained earnings. As the below chart illustrates, on average the market cap/GDP ratios for EM countries are lower than those of developed countries.
Source: World Bank 2012
In essence, a significant gap between market size and economic size exists for many EM countries. As large emerging economies such as China, India and Indonesia make strides toward growth, index construction can be an important consideration when determining desired country exposures.
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