Israel's graduation to "developed market" status in the Morgan Stanley Capital International Index (MSCI) in May 2010 is a much-anticipated event — a tribute to the strides Israel has made in opening its economy to market competition and globalization. This upgrade positions Israel in a new arena, with a large long-term potential for new investments and investors.
However, with the country's graduation from MSCI's Emerging Markets Index come major challenges, including the potential decline of US$2.5 billion of foreign equity investment, according to a new report from the Milken Institute. Israeli-based businesses, government agencies and capital-market regulators will need to step up to compete in this environment with new measures to increase liquidity and broaden the base of portfolio investors, the report says.
"The reclassification is a testament to Israel's success, but also presents some significant challenges," said Glenn Yago, director of Capital Studies at the Milken Institute and head of the Institute′s Israel Center. "The potential outflows and stock reductions could negatively impact Israeli market liquidity in the short term, increase the cost of capital, and reduce overall portfolio investment. Increasing transparency and liquidity can help Israel overcome these new challenges and are required to attract international investors."
The report offers recommendations on how Israel can benefit from the reclassification and deal with its impact on foreign investment.
Typical of graduating countries, Israel will lose investors who focus on emerging markets and will have to attract a different type of investor in the highly funded, but also highly competitive developed markets, including pension and mutual funds that only invest in developed markets. In some cases, graduating countries experience a period of stagnation and decline as former investors leave (outflow) and new ones take time to come in (inflow).
"Reclassification changes the ballgame for the Israeli capital market," said Yago. "This is not a time for 'business as usual′ as reclassification approaches."
According to the report, some market attributes that account for Israel′s success as an emerging market could limit its success among developed-market investors, including:
- Israel comprises about 3 percent of the emerging market index, which makes it heavily weighted in the index, attracting a good amount of both passive and active investment. In the developed market, Israel will comprise about 0.37 percent of the market and have a much smaller "footprint" for index investors.
- Current Israeli market investors are highly concentrated in the United States and Great Britain. Developed-market investors are widely spread throughout the world and Israel-based firms have not historically engaged in marketing on that level.
- Emerging-market investors often employ a regional, rather than industry or sector investing strategy. Israel-based firms must now compete globally in their industry sectors. There are not many Israeli global corporations that have emerged to compete on this basis for international portfolio investment.
- Most foreign investment is concentrated in the country's few large companies. The Israeli market is lacking in mid- and large-sized firms, and small businesses typically sell to foreign firms before they become well-established enough to attract foreign investment and grow into international players.
To meet these challenges, the report offers specific recommendations for Israel's financial sector and public companies and encourages them to act quickly to increase liquidity and enhance corporate governance and transparency. The recommendations include:
- Increase the free float requirement (the percentage of shares of a public company that are available to the investing public) for leading indices.
-- Fully privatize relevant government companies and holdings in large public firms through the TASE and meet MSCI free float requirements to diversify the Israeli market, reduce concentration of ownership and increase competitiveness.
- Expand the universe of visible Israeli firms by encouraging companies that could accomplish a small percentage change in free float market cap through divestment, spin-offs, and diversification of concentrated and centralized holdings. Nine potential companies are suggested in the report: Dan Hotels, Granite, IDB Holdings, Netvision, FMS, Delek Israel, Jerusalem Econ, Industrial Building and Delek Energy.
- Require inward dual listing to expand the universe of visible Israeli firms and outward dual listing to increase free float in the market.
- Create alternative investment products, such as exchange-traded funds, mutual funds, private investments in public equity, and unit investment trusts to represent the Israeli market as a whole (including firms that do not meet the MSCI requirements) and emerging sectors in which Israel has strengths (health, clean tech, and information and communications technology).
- Address local barriers, including changing reporting cycles to follow those of global markets, pursuing required English reporting and considering the alignment of trading hours with global markets.
- Launch strategic marketing and product development initiatives that target mission-related investments.
"Israeli entrepreneurs, venture capital and private equity investors, government and municipal corporations seeking private investment, and project finance markets all need greater liquidity, transparency, corporate governance rules, and reduced concentration of holdings to encourage foreign investors," said Yago. "Without the continuation of financial reforms that deepen and broaden local capital markets, the transmission of savings to investment in Israeli firms, both locally and internationally, could weaken."
The Milken Institute′s assessment of potential outflows differs from previously released analyses, including Merrill Lynch's forecasts in June 2009, which did not include the changes to the MSCI clarified methodology of June 17, 2009.
The Milken Institute used different methodology and examined data from the Bank of Israel, Thomson Financial and conducted extensive interviews with key investors, analysts and representatives from ratings agencies in Israel and the United States.
The report is part of the Institute's ongoing analysis of global capital markets and financial institutions, which includes the design of practical business models, innovative financial tools and policy recommendations to help improve economic conditions.