How to Tell Emerging from Developed Markets

Last week, I wrote that the emerging market stock indexes that Vanguard tracks will be adding mainland China A-shares to their index (click here and for a refresher).  On Tuesday, MSCI, the world’s most popular index creator for non-US stock indexes announced they would not be adding Chinese A-shares to their emerging markets indexes.

MSCI believes there are too many regulatory issues related to non-Chinese owners that could make owning Chinese stocks too illiquid and potentially volatile.  MSCI said they thought that based on current conversations with Chinese regulators, the A-Shares could be included in their indexes as early as 2017.

After my article the other day about China being the second largest stock market in the world when you factor in all of their alphabet soup of stocks (click here for a refresher), a number of people asked me how China could still be considered an emerging market given their massive size.  I heard a number of commentators on Bloomberg and CNBC openly asking the same question.

It turns out that the generally accepted criteria for inclusion in either the developed or emerging market categories (and frontier, which is the real Wild West) is based on per-capita Gross Domestic Product (GDP), which measures the total economic output of a country on a per-person basis.

There are two ways to measure per capita GDP – in US Dollars or factoring in something called purchasing power parity.  Let me start with numbers for the easy to understand measurement: US dollars.

As of December 2013, the GDP per capita in the US was $45,700.  Using this measurement and time period, other developed markets look very similar: Canada is $37,500, Germany is $39,200 and Japan is $37,500 for example.  We’re a little wealthier per person, but the developed markets all in basically the same range.

The differences in emerging markets are wider.  In Mexico, GDP per capital is $8,500, Brazil is $5,800 and Russia is $6,900.   India and Cambodia are poorer, coming in at $1,100 and $900 respectively.

By this measurement, China is in the middle at about $3,500.  That’s why China is still an emerging market despite their colossal size.  Imagine how big they will be when their per capita GDP matches the rest of the developed world.

Now, here’s where it gets a little complicated.  As I mentioned, there is a second measure of GDP per capita that factors in purchasing power parity (PPP).

The basic PPP idea is based on the law of one price: that a hamburger, for example, ought to cost the same thing everywhere.  I’ve written a little more about this here using a fun index from The Economist.

The way that I think about it is simply by looking at prices in St. Louis versus New York City where my sister lives.  Real estate prices are higher, which means that everything costs more.  The people who live there then have to earn more to pay the higher costs.  You can simply think of a PPP adjustment as a cost-of-living factor that equalizes lifestyles.

When you adjust GDP on a PPP basis, China jumps from $3,500 in per capita GDP to $11,900.  The US per capita GDP jumps to $53,000, but the jump isn’t quite as big so that instead of being 13 times larger compared to 4.5 times as big.  As incomes in China grow, the difference between the PPP per capita and the US dollar per capita will converge.  Click here for a complete list – I used the World Bank data.

Even though China is growing their PPP adjusted per capita growth at 7.1 percent per year while we grow 1.5 percent per year, it’s going to be a very long time before they graduate from being an emerging market to a developed economy.