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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 US firm has rejected inclusion of A-shares1 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 we detect 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 licence; 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.

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-$15 billion which 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 capitalisation of almost $7 trillion.

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, institutionalised mind-set, 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.

MSCI’s decision has no practical application for us as a stock-picker. We invest in companies based on strict criteria such as sustainable earnings and progressive capital management. An influx of index-tracking capital will not answer to such considerations of quality.

It is important to Beijing that it gets the nod from MSCI so it can evidence further progress in its drive to deregulate and liberalise 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.

Image credit: Ikon Images / Alamy Stock Photo

This article was published in Business Insider on 13th June 2017

1A shares are ‘onshore’ shares in mainland China-based companies that trade on the Chinese stock exchanges such as the Shanghai Stock Exchange and the Shenzhen Stock Exchange.

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