THE DEVELOPMENT OF THE ROMANIAN STOCK MARKET FROM FRONTIER TO THE EMERGING MARKET STATUS

Abstract

The stock markets from around the world are divided by different investment decision providers, like MSCI, S&P or FTSE, into three main categories, according to their level of development: frontier, emerging and developed markets. The majority of the stock markets of European Union countries belong to the developed or emerging market category. There is also a third category, the so-called frontier markets, and in the EU we can only find six countries that fall into this category, one of which is Romania. Does the Romanian capital market really still belong to this category or is it able to promote to a better status? In this paper, we will attempt to investigate this issue.

Headnote

Abstract:

The stock markets from around the world are divided by different investment decision providers, like MSCI, S&P or FTSE, into three main categories, according to their level of development: frontier, emerging and developed markets. The majority of the stock markets of European Union countries belong to the developed or emerging market category. There is also a third category, the so-called frontier markets, and in the EU we can only find six countries that fall into this category, one of which is Romania. Does the Romanian capital market really still belong to this category or is it able to promote to a better status? In this paper, we will attempt to investigate this issue.

Keywords: stock market, frontier markets, emerging markets, indexes

1. Introduction

The 2008 financial crisis showed, once again, how dangerous capital markets can be because of deregulation, sophisticated derivatives, toxic financial products and so on. But, dangerous or not, capital markets are essential for financing any economy. This statement is even more valid when we are talking about the "young" market economies of Central and Eastern Europe, because of the massive deleveraging caused by the foreign banks that are present here. In the case of Romania alone, we are talking about more than 10 billion Euro cash-out of these banks since 2008. Moreover, there was strong reluctance from banks to grant new loans to companies. Therefore, amid a crisis, local capital markets may and should partially replace the banking system in financing the economy of a country.

In Europe, the majority of stock markets of European Union countries belong to the developed or emergent market category. According to the Morgan Stanley Capital International (MSCI) classification, most western European countries are considered to have a well-developed capital market (see table no. 1), while none of the new members from Central and Eastern Europe are included in this category. Only three countries from CEE (Poland, the Czech Republic and Hungary) are considered to have capital markets meeting the criteria so as to be placed in the emerging market category, while the rest are in the frontier market basket or unclassified.

As we can see from this table, we have in the EU six countries that are considered to be frontier markets: Bulgaria, Croatia, Estonia, Lithuania, Romania and Slovenia. Some of them, like Slovenia or Estonia, belong to this group mostly because they are small countries and, accordingly, they have small economies and capital markets. Why Romania is in this category and how it can promote to the emerging market status, these are questions that we will attempt to answer in the following pages.

2. Frontiers markets in the world and in Europe

There are different investment decision providers: Morgan Stanley Capital International (MSCI), Standard and Poor's (S&P) and Financial Time Stock Exchange (FTSE), which divide capital markets around the globe into three categories: frontier, emerging and developed. What renders a market fit for one of these categories?

According to Morgan Stanley Capital International (MSCI), there are three criteria that guide the division of capital markets around the world into developed, emerging and frontier:

1. Economic development

2. Size and liquidity of the market

3. Market accessibility criteria

The economic development criteria refers to the country's GNI (Gross National Income) per capita, which should be 25% above the World Bank high income threshold for three consecutive years. The fulfilment of this criterion is required only for granting the developed market status.

If the first criterion refers to the macro economy, the second descends to the companies' level and also refers to emerging and frontier markets. The size and liquidity criterion refers to the company size, security size (float market capitalization) and security liquidity. This second criterion requires that a minimum number of companies cumulatively fulfil all these criteria (a minimum of five companies for developed markets status, a minimum of three for emerging markets and two for frontier markets - see table no. 2).

The third set of criteria refers to market accessibility and is more qualitative and related to legal issues. More specifically, these criteria refer to the degree of openness to foreign ownership, ease of capital inflows or outflows, efficiency of the operational framework and stability of the institutional framework.

As we can observe from the abovementioned classification, frontier markets are countries with an investable stock market, but either they do not have large companies listed or enough liquidity, either, more often, they are not open enough to foreign ownership or they do not have an efficient operational framework, and so on.

As we can see in the picture below, in the frontier markets category we can find three types of countries14:

a) Countries having abundant natural resources, like: Kazakhstan, Saudi Arabia, Mongolia, Nigeria etc.

b) Countries with a large population, usually also very young, like: Pakistan, Nigeria, Bangladesh, Vietnam, Argentina etc.

c) Countries having a relatively deep financial market: Romania, Kuwait etc.

At the end of the 16th century, the world economic system started to develop in such a way that the "core" countries (the developed markets) were selling high profit consumption goods to the peripheral countries, in exchange for cheap labour and natural resources, while the semi-peripheral countries were somewhere in the middle, providing natural resources and relatively cheap labour to the core countries and selling some products with large profits to the periphery15. This situation was very well described and illustrated by Immanuel Wallerstein in his famous World-System Theory model:

In terms of capital markets, the actors and the pattern are more or less the same. The core countries are replaced by the developed markets, the semi-peripheral by the emerging ones, while the peripheral countries are replaced by the frontier markets. The financial flows have quite a similar pattern to commercial activities: developed markets are investing some capital in the frontier and emerging markets in exchange for ownership (or big stakes of stocks) of some local companies. The majority of these companies have one or more of the following characteristics: they have natural resources (oil, gas, wood, metals etc.), they employ cheap labour force, they have a monopoly (like energy, water or gas supply) or they are of strategic importance to the financial sector (banks, insurance companies etc.).

The growth potential for the frontier markets is very big, but for now, the same is the gap between them and the rest of the world. Despite the fact that the frontier markets countries account for 24% of the world's land area and 22% of the total population, they have only 8% of the world GDP16.

From time to time, various countries manage to make the step from the periphery to the semi-periphery or even to the core group (see, for example, South Korea). The same goes for the capital markets of different countries. Just last year for example, two countries were promoted to the emerging market status (Qatar and the United Arab Emirates). However, the reciprocal is also valid. It came as no surprise when, in 2013, Greece was downgraded from the developed market status to the emerging markets, or when Morocco was downgraded to a frontier market from the emerging market status, in the same year17.

3. Romania as a frontier market of the European Union

As we can see in the map below, Romania is currently a frontier market in the European Union, together with Slovakia, Bulgaria, Croatia, Estonia, Lithuania, Latvia and Slovenia. Other European countries classified in this category are Serbia, Ukraine, Georgia, Macedonia or Bosnia and Herzegovina (see chart no. 1).

Fortunately, Romania is not merely one country among the other frontier markets, but finds itself among the most important ones; actually, it was recently included in the top ten most prominent and promising frontier markets. Furthermore, Romania is the only frontier market in Europe to be found in the top ten. According to their weight in the MSCI Frontier 100 Index, the ten most promising frontier markets are:

Moreover, as we have this well-known BRIC acronym (Brasil, Russia, India and China) for emerging countries, on the capital markets, one more was invented for frontiers markets: NIROPA, which includes Nigeria, Romania and Pakistan.

Romania currently has six companies that are included in the MSCI Frontier 100 index: Banca Transilvania, Petrom, Romgaz, BRD Groupe SG, Transgaz and Electrica. Due to re-arrangements in the index (after the promotion of Qatar and the United Arab Emirates to the emerging status last year and after the inclusion of the Romanian company Electrica), the share of the six Romanian companies in the index grew from 1.5% to 2.7%, and then to 4.05%. This increase also means that more investments are expected on the Romanian capital markets due to the mandatory re-allocations in the investment funds' portfolios. The weight of each Romanian company in the index is the following: Banca Transilvania 1.28%, Romgaz 0.68%, BRD-Groupe SG 0.58%, Petrom 0.55%, Electrica 0.49% and Transgaz 0.47%21.

How far is Romania from the emerging market status? As we can see in Table no. 2, there are two types of criteria required for promoting to the emerging market category: quantitative and qualitative criteria (the sustainability of economic development criterion is required only for gaining access to the developed market status). Concerning the qualitative criteria necessary for promoting to the emerging market status, such as those regarding market accessibility, they are generally already fulfilled by the Bucharest Stock Exchange (BSE). More problems are encountered with the quantitative criteria, therefore we will insist more on those.

Regarding company size, more precisely full market capitalization, four companies from the BSE are currently fulfilling with ease the minimum requirements for emerging markets:

1. SNP - Petrom OMV, with a market capitalization of 5.378 mm USD and a float market 503 mm USD capitalization ;

2. SNG - Romgaz, with a market capitalization of 3.500 mm USD and a float market capitalization over 700 mm USD;

3. BRD - BRD Groupe SG, with a market capitalization of 1.937 mm USD and a float market capitalization 772 mm USD;

4. TLV - Banca Transilvania, with a market capitalization of 1.578 mm USD and a float market capitalization 1.350 mm USD22.

There is also Fondul Proprietatea (FP), with a market capitalization of 2.692 mm USD, which fulfils the company size criterion, but closed investment funds are usually not taken into account in these evaluations. However, there is one more company currently listed on the BSE that is close to meeting the size criterion: Electrica, with a market capitalization of 1.029 mm USD.

As it becomes apparent, the criterion regarding the size of the market, which requires at least 3 companies over 1.260 mm USD capitalization, is clearly fulfilled (on the Bucharest Stock Exchange there are four companies over this required threshold). As we can see from the above calculations, the criterion regarding the security size, more precisely the float market capitalization over 630 mm USD, is also fulfilled by three of the same companies: Banca Transilvania, Romgaz and BRD Groupe SG.

We were supposed to have more companies, like the four mentioned before, on the BSE. We actually did have these companies on the BSE in the past, but foreign capital has not done much to help the Romanian capital market. A very large company, the car maker Dacia, was listed on the Bucharest Stock Exchange in the past, but when Renault bought it, Dacia was delisted by the former. Another example is when BCR Bank (the largest Romanian bank) was bought by Erste Bank, they pledged through the privatization contract that in three years they would list it on the BSE - eight years have passed since then and the provision has still not been respected. With any of these two companies listed on the BSE, Romania would be probably among the emerging markets or at least closer to them.

Problems still exist with the third criterion regarding security liquidity, more precisely with the ATVR (Annualized Traded Value Ratio). There is a trap in this respect, which we may refer to as the 'liquidity trap'. On the one hand, there is not enough liquidity on the BSE because there are not enough large investors, and, on the other hand, there are no large investors because there are not enough large companies and /or companies with large free float. The solutions to the liquidity trap can be, on the one hand, new listings on the BSE and/or increasing the free float of the existing companies and, on the other hand, the promotion to the emerging market status in order to attract a different category of investors.

New listings can come in from the IPOs (Initial Public Offers) for some big state-owned companies like: Hidroelectrica, Constanta Port, CEC Bank or Aeroporturi Bucuresti. Or from some local privately owned companies like the telecom RCS & RDS. An increase in the free float of some of the existing companies from the BVB can be achieved if the Romanian state chooses to sell more stakes in companies like Petrom, Romgaz or Electrica. More liquidity can also be generated by sales made by Fondul Proprietatea that owns stakes in companies already listed like Petrom, Electrica, Romgaz, Nuclearelectrica and so on. But, as we have already mentioned, we need big investors ready to buy these new stakes, and they are not easy to find. This is why it is so important to promote to the emerging market category in order to access more and larger investors.

4. Conclusions

Currently Romania is the most promising frontier market from Europe, but nevertheless still a frontier market. Being a frontier market, the Romanian stock market still has to grow more than 50% from now on in order to reach the 2007 levels, while developed capital markets like the United States or Germany already overpassed that levels with two digits percent.

But, the biggest concern is that being a frontier market, only one type of foreign investors are qualified to invest here, namely those with a risk tolerance above average, more precisely the investments funds that are dedicated to frontier markets . The problems with these investment funds are that they are very limited in assets and often speculative. Therefore Romania is perceived as being interesting only for some niche portfolios.

The incentives for Romania to promote in the emerging markets category are, after all, the additional funds that will be available to be invested here. The funds allocated for the frontier markets worldwide are somewhere around 10-15 billion dollars, while those allocated for emerging markets are almost one hundred times bigger, somewhere around 1.400 billion dollars23. Therefore, the Romanian capital markets can get over 1 billion dollars in new investments, even if gets just a share of 1% in the emerging markets index.

The Romanian capital market (Bucharest Stock Exchange) overpassed in some aspects capital markets that are emerging markets, like Hungary or Czech Republic. For instance, the number of the companies listed on the main market on the Bucharest Stock Exchange (81 companies24) is much bigger than that on Budapest Stock Exchange (46 companies) or on the Prague Stock Exchange (23 companies25). The domestic capitalization is also bigger in Bucharest compared with Budapest (19.2 bn Eur26 compared with 16.4 bn Eur27) and not so far compared to the capitalization of Prague (24.5 bn Eur ), but the liquidity is much lower (0.17 bn Eur monthly turnover on Bucharest compared with 1.8 bn Eur in Budapest and 1 bn Eur in Prague) . And here we come back to the 'liquidity trap' story and that is why is vital to Romania to promote in the emerging market category in order to attract strong and steady foreign investors, not just opportunistic and occasional ones.

Footnote

12 MSCI Market Classification, available at: https://www.msci.com/market-classification (last accessed 15.05.2015)

13 MSCI Market Classification Framework available at: https://www.msci.com/documents/1296102/1330218/MSCI_Market_Classification_Framework.pdf/d93e536 f-cee1-4e12-9b69-ec3886ab8cc8 (last accessed 15.05.2015)

14 D. Keller (2014) - Morocco Grabs Limelight as Companies Focus on Frontiers, Wall-Street Journal, Oct. 14, (last accessed 10.04.2015)

15 Jacques Bazen (2011) - Sustainable economic development, Presentation for ECPYN Winterschool Soest, The Netherlands

16 Gavin Serkin (2015) - Frontier: Exploring the Top Ten Emerging Markets of Tomorrow, Bloomberg Financial, Wiley, p. 2

17 MSCI Classification available at https://www.msci.com/market-classification (last accessed 15.05.2015)

18 D. Keller (2014) - Morocco Grabs Limelight as Companies Focus on Frontiers, Wall-Street Journal, Oct. 14

19 iShares MSCI Frontier Markets 100 ETS - http://www.ishares.com/us/products/239649/ishares-mscifrontier-100-etf (last accessed 30.05.2015)

20 MSCI Frontier Markets 100 Index - https://www.msci.com/resources/factsheets/index_fact_sheet/mscifrontier-markets-100-index.pdf (last accessed 30.05.2015)

21 http://www.ishares.com/us/products/239649/ishares-msci-frontier-100-etf (last accessed 30.05.2015)

22 Author's calculation based on data from the Bucharest Stock Exchange, May 2015, http://www.bvb.ro/ (last accessed 30.05.2015)

23 R. Pricop (2014) - Seful BVB: In drumul spre statutul de piata emergent vor veni fluxuri mari de capital, Ziarul financiar, March 20

24 Bursa de Valori Bucuresti, http://www.bvb.ro/FinancialInstruments/Markets/Shares (last accessed 30.05.2015)

25 CEE Stock Exchange Group, http://www.ceeseg.com/static/cms/sites/ceeseg/en/media/pdf/factsfigures.pdf (last accessed 30.05.2015)

26 BVB Trading Data, http://www.bvb.ro/press/2015/APRIL%202015_EN.pdf (last accessed 30.05.2015)

27 CEE Stock Exchange Group, http://www.ceeseg.com/static/cms/sites/ceeseg/en/media/pdf/factsfigures.pdf, (last accessed 30.05.2015)

References

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