Israel has made great strides in opening its economy to market competition and globalization. Recognizing this progress, Morgan Stanley recently announced that Israel will graduate from the MSCI Emerging Markets Index and achieve developed market status.
While this shift represents the maturation of the Israeli economy, it also brings significant risks, warns this research report from the Milken Institute. Israel must act quickly to address deficiencies in the local capital markets that could constrain the potential advantages of reclassification — namely, the ability to access the larger pool of foreign investors represented in developed market indices.
A transition period of stagnation and negative portfolio flows is likely as passive emerging market investors exit quickly and incoming developed market investors, both passive and active, penetrate at a slower pace. The report aims to outline the risks inherent in graduation and propose specific steps to minimize negative impact.
The Milken Institute's findings suggest that investor reaction could cause an outflow as high as US$2.5 billion, while the size of potential inflows that might offset this loss is unclear, given the sector-based investment strategy commonly used by developed-market investors.
If significant regulatory and market changes are not made to enhance Israel's welcome and historic transition to developed market status, the potential for net portfolio outflows and portfolio stock reductions could present a significant risk affecting liquidity, the cost of capital to Israeli firms and projects, and overall investment and economic performance.
Israel and the Global Equity Market outlines crucial steps to increase the attractiveness of the market by making it more open and liquid and by overcoming information asymmetries between firms and investors, both local and foreign.
