FT Mastering Growth article

This article was published on Tuesday on FT.com.

There is much excitement about the rise of a global middle class, yet emerging economies are still a long way from developing a mass investment culture.

A look at some of the common definitions of middle class should be enough to sound a note of caution to anyone hoping to see a rapid growth in the investing classes. The loosest definition includes all those who have exceeded the World Bank’s poverty line of $2 a day (adjusted for purchasing power differences), while a more demanding one puts the poverty threshold at $10 a day.

According to FT research, there were 2.8bn people living between these two levels in the developing world in 2010. But even the higher amount is well below the official poverty line in the US, according to research by Martin Ravallion, a former director of research at the World Bank.

Even a cursory glance at such a disparity should be sufficient to confirm that any “middle class” in the developing world is much likely to be poorer than its namesake in developed countries.

Another approach to determining what constitutes a middle class relates to car ownership. According to an authoritative paper, there were about 160m cars in G20 developing countries in 2010: adjusting for household size, that would amount to a middle class of about 550m-600m people.

The investment universe is presumably a subset of this number, since it is hard to imagine many investors who do not own a car. So a blanket use of the term middle class does not, in itself, indicate a threshold at which consumers are sufficiently prosperous to become investors.

Therefore, while it does make sense that above a certain level – and as their disposable income increases – individuals can become private investors, it is hard to establish just exactly what that threshold is. One reason for this is that middle-class investors typically eschew financial assets until they become relatively secure in their wealth.

“It’s not that they’re not investing,” says Shiv Taneja, managing director of Cerulli Associates, a research firm specialising in fund distribution trends. “It’s just that they’re not investing in financial assets in the same way as they do in the US and elsewhere.”

Investors typically put their money into tangible assets, such as real estate or gold, before they are lured into the financial markets.

Susan Lund, a partner at the McKinsey Global Institute, uses the developed world to demonstrate why there is no clear income threshold for equity investment. Although it is true that Anglo-Saxon countries have a strong equity culture, this culture is much weaker in Japan and continental Europe, so even the comparatively wealthy middle class members of rich countries often eschew equities.

A lack of trust in regulation and financial institutions is one reason why the emerging middle class can be wary of financial assets. Protection for minority shareholders is often seen as inadequate in emerging economies.

Ms Lund says: “You need a transparent marketplace where minority shareholders are confident they are not being fleeced at the expense of the owners of the company.” Such institutional trust takes time to build.

In China, for instance, the state typically has a majority stake in listed companies, so there is at least the potential for a conflict of interest between the regulators and minority investors. This may help to explain why individual investments in equities in the country are generally confined to day trading.

Those emerging market equity investors who do favour long-term investment usually focus on their own country, as regulations tend to discourage – if not forbid outright – investment overseas. Cerulli’s Mr Taneja says: “Most [emerging] markets are highly protectionist, very domestic, highly fixed-income focused and with massive amounts of government intervention.”

Chile is a rare exception to this pattern. Retirement investment in individual capital accounts was made compulsory for employed workers in 1981. As a result, a local equity culture, which includes significant overseas investments, has developed. Some African countries, including Nigeria, have adopted this model.

When developing country investors do look at putting money into international assets, they mostly turn to developed markets. That is because such assets, which tend to provide low returns at relatively low risk, give them better diversification than they would find in other emerging markets.

Expatriate investors from developing economies provide another partial exception to the reluctance to make cross-border investments. Remittances from expats have played an important role in driving equity investment in Africa in recent years.

Malick Badjie, a director of Silk Invest, a frontier market investment specialist, says: “You can’t discount that as a significant factor in terms of the growth of the market.”

Rising prosperity in emerging economies is one of the most positive trends of our time, but it will be a while before developing countries can replicate the mass investment culture of the Anglo-Saxon world.