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China and the MSCI – third time unlucky

Index provider MSCI has declined to include China A-shares* in its influential regional indices for the third consecutive year, saying it would retain the proposal as part of its 2017 market classification review. It is what we predicted would happen.

The decision to delay means it was third time unlucky for Beijing, although MSCI did acknowledge that Chinese authorities had made significant progress. It said further positive developments might prompt it to revisit the issue ahead of its annual review next June.

At stake had been a potential $20 billion that could have flowed into mainland equities at partial inclusion of 5% of the A-shares free float adjusted market cap. This would have accounted for 1.1% of the MSCI Emerging Markets Index. Full inclusion would have seen the renminbi-denominated shares of mainland China-based companies, which trade on the Shanghai and Shenzhen exchanges, command 18% of MSCI’s index.

In the run-up to this decision, the Chinese were confident they had done enough to address the shortcomings which MSCI had identified a year ago, chiefly around market access and company ownership problems that fall short of international norms.

Beijing’s impatience had been palpable. In April, state media Xinhua thundered, “Too much hesitation serves no one’s interests.”

But after gathering feedback from market participants, MSCI said international institutional investors wanted to see further improvements in the accessibility of A-shares before they were included in the regional index.

Evidently, Beijing has made progress. In February, it introduced a registration system allowing all eligible foreign investors to receive up to $5 billion in quota, in line with their assets under management. It means sufficient quota should be available if needed. Previously, investors had to seek permission each time they hit an arbitrary cap.

The foreign-exchange regulator also relaxed rules so foreign investors can repatriate capital out of the country on a daily basis, rather than weekly. Plus, it shortened the capital lock-up for all investors from a year to three months.

And on May 6, authorities clarified that securities held in separate accounts belonged to clients of the fund managers overseeing them. They had already resolved similar anxieties over proprietary ownership under the Stock Connect cross-border trading link between Shanghai and Hong Kong.

However, there is still more to do. Since MSCI’s verdict last June, Beijing has intervened in the markets more than once. During last summer’s stock market rout, 1,400 companies voluntarily halted trading of shares in early July. That represented half of A-share liquidity.

Voluntary trading suspensions create significant liquidity risks for investors. They prevent calculation of fair value and the ability to sell in a downturn.

Then, at the start of the year, China’s three main bourses imposed a circuit-breaker mechanism to suspend trading whenever the benchmark CSI 300 Index rose or fell by 5%, or cease it altogether if a 7% limit was breached.

After trading had to be halted, the mechanism was scrapped within days and the head of China’s securities regulator, Xiao Gang, was replaced by Liu Shiyu. While Beijing was seen to act, in reality Liu’s powers are limited and the real decision-makers remain within the State Council.

Beijing responded to calls for change by publishing rules that restrict such trading halts. But this only happened in late May, and so it has not been tested. The market cannot yet be confident that authorities won’t intervene as soon as fears over capital outflows resurface.

Other issues remain, including a desire to see Chinese exchanges remove anti-competitive measures that limit the investment and hedging vehicles available to international investors. There is also limited sell-side coverage of China’s universe of nearly 3,000 listed companies.

It may seem illogical that not a single stock from the world’s second-largest economy appears in regional indices. Yet Chinese companies are already represented via Hong Kong-listed H-shares and, since last November, by Chinese American Depository Receipts (ADRs).

As active stock-pickers, we are agnostic as to whether MSCI includes A-shares or not. It does not affect our view of whether a company is good or bad. We would not have felt any need to adjust portfolios even if MSCI had decided on inclusion. Our comfort with A-shares will grow as we find more companies that are ready to confer rights of ownership on outside shareholders. We are seeing some encouraging signs of progress in governance.

As active stock-pickers we are agnostic as to whether MSCI includes A-shares or not.

Still, until now, finding companies that are transparent has been a problem. It was moot whether including China in MSCI indices now would have helped in this regard. Passive money does not answer to considerations of quality.

But while this presumed influx of cash might have underpinned valuations -- at least temporarily -- Beijing should use MSCI’s prompts as an opportunity to signal a retreat from the kind of ad hoc support it has provided in the past.

Markets work best when there is a level playing field. Catering to the retail investors who dominate Chinese stock markets potentially deters active stock-pickers, as prices are more likely to be divorced from fundamentals. Yet it is patient, long-term capital that ought to be the prize from market opening, including that from domestic sources such as China’s growing insurance funds.

MSCI is not restricted to its annual review and could decide to include A-shares at any point, with a year’s grace for implementation. That gives China a carrot to resolve residual issues in good time. As we said before MSCI’s announcement, if China had been granted a seat at the table now, it would have been a concession.

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

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

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, as well as political and economic risks. These risks are enhanced in emerging-markets countries.

Ref: 24533-150616-2