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A symbolic stepping stone

A symbolic stepping stone

By June 20, we will know whether global index operator MSCI has finally relented to allow mainland Chinese stocks entry into its widely tracked regional equity benchmarks.

The U.S. firm has rejected inclusion of A-shares from the world’s second largest economy for the past three years, citing concerns over the inability to access, trade and cash in stocks freely.

But there may be a marked change in MSCI’s accommodation this year. Far from endorsing Beijing’s effort to address previous impediments surrounding ownership rights, capital repatriation limits and trading suspensions, the index creator has instead modified its admission criteria to such a degree that China’s entry now appears a formality.

It has swapped the framework by which global investors would access A-shares from schemes restricted by investment quotas to Stock Connect, the trading loop directly linking the exchanges of Hong Kong, Shanghai and Shenzhen.

In one swoop, it is side-stepping a number of constraints. Stock Connect has no quota requirements. It is open to all investors without need of a license, and it has no restrictions on capital mobility since trading happens in offshore yuan (CNH) – a freely convertible currency not subject to capital controls. In short, it ticks the key boxes on access and liquidity.

Further, MSCI has included only large-cap companies and excluded dual-listed stocks that feature in the MSCI China Index to reduce overlapping exposures. It has also exempted constituents suspended for more than 50 days over the previous 12 months.

What it boils down to is just 169 stocks eligible for inclusion, representing 5% of all listed mainland companies. If approved, A-shares would account for 0.5% of the MSCI Emerging Markets Index – less than half the weighting of last year’s proposal for inclusion.

We see this latest approach as indicative of MSCI’s enduring caution – something we share when it comes to investing in emerging markets. MSCI was unable to incorporate Shenzhen Stock Connect last year as that scheme was still pending, but it is now up and running and has improved A-share investibility.

Still, the $5 billion to $15 billion that could flow into A-shares from funds passively tracking MSCI’s Emerging Markets Index will be marginal in the context of China’s onshore bourses’ combined market capitalization of almost $7 trillion.

Hence, we view MSCI’s likely action as largely symbolic.

Hence, we view MSCI’s likely action as largely symbolic. Besides, implementation may take until June next year. After that the weighting of A-shares is likely to go up only slowly, in line with broad-scale improvements in accessibility and liquidity.

As it stands, Stock Connect is far from perfect. It takes several hours between buying and receiving shares. For some investors this poses an unpalatable credit and counterparty risk. Stock Connect is also subject to daily trading limits, which run contrary to freedom of access.

Another weakness is that China has the highest number of voluntary trading suspensions worldwide, even after a regulatory drive in May last year to curtail the practice. Pre-approval requirements on certain financial products and a lack of hedging tools highlight further areas for improvement.

These gripes apart, given how tight the scope of MSCI’s proposed framework is, we see little reason for institutional investors not to welcome China in.

From a developmental perspective, index-driven money should offer a foil to the retail speculation behind most A-share trading. Indeed, index inclusion may begin to foster a longer-term, institutionalized mindset, exposing local managements to global standards of accountability. Positive shareholder activism can propel improvements in profitability, and profit-sharing, to everyone’s benefit. That said, the current level of foreign participation is miniscule.

It is important to Beijing that it gets the nod from MSCI so it can evidence further progress in its drive to deregulate and liberalize its capital account. But it is a stepping stone. Consider the markets that stand to lose as money in emerging markets shifts inexorably to China over time. Eventually, that might be the bigger story.

Important Information

Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging market countries.

Indices are unmanaged and have been provided for comparison purposes only. No Fees or expenses are reflected. You cannot invest directly in an index.

The MSCI information may only be used for your internal use, may not be reproduced or redisseminated in any form and may not be used as a basis for or a component of any financial instruments or products or indices. None of the MSCI information is intended to constitute investment advice or a recommendation to make (or refrain from making) any kind of investment decision and may not be relied on as such. Historical data and analysis, should not be taken as an indication or guarantee of any future performance analysis forecast or prediction. The MSCI information is provided on an “as is” basis and the user of this information assumes the entire risk of any use made of this information. MSCI, each of its affiliates and each other person involved in or related to compiling, computing or creating any MSCI information (collectively, the “MSCI” Parties) expressly disclaims all warranties (including without limitation, any warranties of originality, accuracy, completeness, timeliness, non-infringement, merchantability and fitness for a particular purpose) with respect to this information. Without limiting any of the foregoing, in no event shall any MSCI Party have any liability for any direct, indirect, special, incidental, punitive, consequential (including, without limitation, lost profits) or any other damages (www.msci.com).

Image credit: Ikon Images / Alamy Stock Photo

ID: US-150617-34550-1