By Tom Arnold
LONDON (Reuters) - Disruption in emerging and frontier markets has strained liquidity and disrupted trading functions, triggering what could become a shake-out in benchmark indexes.
Indexes can funnel billions of dollars from index-tracking funds into developing economies. Changes in the stocks and bonds that make up the indexes can change where those funds go, and in what amount.
But the impact of the coronavirus pandemic has hit stock and bond markets, limiting liquidity and making it harder to calculate prices. Regulators from India to South Africa have tried to control the damage by, for example, shortening trading hours or banning short selling.
Index providers are also trying to mitigate the fallout. J.P.Morgan and FTSE Russell last month delayed including Chinese bonds and stocks in their benchmarks.
MSCI said this week it would proceed as planned in May with its semi-annual review of its indexes. However, it will postpone adding Kuwait to its emerging-market equity index because of investors' ability to prepare for the move.
"As of today, the majority of global markets are functioning normally," said Sebastien Lieblich, MSCI's global head of equity solutions. "Stock exchanges in Bangladesh, Jordan, Palestine and Sri Lanka are still closed, but these have a very marginal impact on whether we should postpone or cancel our index review."
FTSE Russell decided last month to split the scheduled March inclusion of China A-shares and Saudi Arabian stocks into its emerging market index across two tranches in March and June.
The decision was prompted less by concern about liquidity in those markets and more about traders' ability to raise funds to buy the stocks when other markets were facing liquidity shortages, said Joti Rana, head of governance and policy, Americas, at FTSE Russell.
"In recent weeks, the buy and sell spreads on pricing has been quite large, so that means getting a true price for a stock can be difficult if it's illiquid, and that illiquidity is seen more at the small cap level," Rana said.
Markets have stabilised in recent days, raising hopes that by the time indexes are re-balanced in coming months, liquidity shortages and regulatory measures, many of which are temporary, will have eased.
And in frontier markets - the smallest and with slimmer liquidity volumes - even where capital controls have been rolled out, FTSE Russell can choose not to make immediate changes to its frontier index unless one of its clients is affected, Rana said.
With a rising tide of distressed credit due to the market turmoil, changes to fixed-income indexes could be significant.
FTSE Russell generally excludes defaulted entities from its bond indexes, said Nikki Stefanelli, head of fixed income at FTSE Russell.
JPMorgan still includes countries in default within its Emerging Market Bond Index. It pushes them out when trading becomes difficult, as it did with Venezuelan sovereign and state oil firm PDVSA’s bonds last year, after U.S. sanctions halted nearly all trading in them.
A bigger change to bond indexes may come from rating downgrades.
South Africa lost its final investment-grade rating last month when Moody’s downgraded its sovereign credit rating to "junk" status. That will lead to its being excluded from the World Government Bond Index from the end of April.
Of the handful of countries rated at triple B, Uruguay and Romania could be vulnerable to a possible rating downgrade that prompts their exit from investment-grade bond indexes, said Nick Eisinger, principal, fixed income emerging markets at Vanguard.
"We are looking at that and what it would mean for crossover accounts as some holders of investment-grade credit would no longer hold it," he said.
(Additional reporting by Rodrigo Campos and Karin Strohecker)