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Fourth Time’s the Charm: Chinese Stocks Join MSCI Emerging Market Index

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Fourth Time’s the Charm: Chinese Stocks Join MSCI Emerging Market Index

The long-coveted inclusion of Chinese stocks will bring increased investment from overseas. Will it also spark reforms?

Fourth Time’s the Charm: Chinese Stocks Join MSCI Emerging Market Index
Credit: Flickr/ Suvcon

Chinese stock investors have been given an early Christmas present from New York. After three previous rejections, U.S. index provider MSCI Inc. announced Tuesday it would include China “A” shares in its emerging market indices from June 2018, a move that should boost international investment in the $7.5 trillion mainland China stock market.

According to MSCI research analyst Chin Ping Chia, the move could see up to $18 billion globally flow into Chinese stocks as overseas investors adjust their weightings in the MSCI Emerging Markets (EM) index, which is tracked by an estimated $1.6 trillion in assets. Currently, foreign investors own less than 1.5 percent of China A shares, which are traded on the Shanghai and Shenzhen bourses.

Chinese companies listed overseas already account for 28 percent of MSCI’s EM index, but the addition of A shares could raise this to 40 percent. Ultimately, full inclusion of the Chinese market into international indices could see more than $340 billion of foreign capital flow into the world’s second-largest economy, MSCI said.

“International investors have embraced the positive changes in the accessibility of the China A shares market over the last few years and now all conditions are set for MSCI to proceed with the first step of the inclusion,” MSCI managing director Remy Briand said. “The expansion of Stock Connect has been a game changer for the market opening of China A shares.”

MSCI attributed its move to both the relatively new Stock Connect, which connects the Shanghai and Shenzhen stock exchanges with Hong Kong, and the loosening by local Chinese bourses of restrictions on index-linked investment vehicles. Just 222 China “A” large capitalization stocks will be admitted initially, representing 0.73 percent of the MSCI Emerging Markets Index at a 5 percent partial inclusion factor, under a two-step process planned for May and August 2018.

According to Credit Suisse, most of the 222 stocks will be financial and industrial companies, many of them state-owned.

Briand said MSCI “is very hopeful that the momentum of positive change witnessed in China over the past years will continue to accelerate.”

As previously noted by Pacific Money, the inclusion of more Chinese stocks into global indices should raise the profile of its mainland market, drawing in more of the around $2 trillion invested globally in emerging market equities. Robert Mann, senior portfolio manager at Nikko Asset Management, suggested the move would help balance capital outflows from China.

“They want more foreign money in China, and when that happens they can let more Chinese money go overseas to balance it up. They recognize that the imbalance is caused by not enough foreign investment in China,” he said.

Other fund managers also welcomed the decision, along with Chinese regulators.

“Given the size and importance of China as an economic superpower, I think this is a historic moment,” State Street Global Advisors senior managing director Kevin Anderson told Reuters.

“It’s a long-awaited and much-debated decision in the past, and I think it’s more than symbolic as it will create additional flow of capital and potentially a new segment of institutional investors in the China market.”

The China Securities Regulatory Commission, which has overseen reforms of the Chinese market, said: “The inclusion of ‘A’ shares in the MSCI index is in line with the inevitable needs of international investors and reflects the confidence of international investors in the good prospects for China’s economic development and stability of the financial market.”

However, the prospect of full inclusion for China A shares appears more uncertain.

MSCI noted that international institutional investors viewed the large number of suspensions in trading of China A shares as “an outlier compared to other international markets.” In May, it highlighted that more than 100 such stocks were suspended, “by far the highest in the world.”

As a result, it decided that only large cap stocks not in trading suspension would be included into its indices, as well as those accessible through Stock Connect.

Further inclusion “will be subject to a greater alignment of the China A shares market with international market accessibility standards, the resilience of Stock Connect, the relaxation of daily trading limits, continued progress on trading suspensions, and further loosening of restrictions on the creation of index-linked investment vehicles,” MSCI said.

Other analysts have warned that China’s large portion of the EM index made investors overexposed to Chinese stocks, compared to those from other emerging economies such as India or Southeast Asia. Heavy-handed interventions by Chinese regulators in 2015 to stem a market crash sparked fears of a new global financial crisis, adding to concerns over the opaqueness of Chinese companies and their corporate governance under the communist-ruled system.

Muted Reaction

The initial market reaction to MSCI’s announcement was relatively muted, with the Shanghai Composite Index moving between positive and negative territory before a late rally saw it finish 0.5 percent higher Wednesday. The bourse has only gained 1.7 percent in 2017, compared to the 24 percent rise in the MSCI China index.

“We view this announcement as an important milestone in the integration of China’s equity markets with the rest of the world,” Morgan Stanley analyst Jonathan Garner said. “But there is unlikely to be a significantly positive impact on A share index performance near term.”

However, for Chinese President Xi Jinping, the MSCI decision represents a political victory, albeit only a cautious acknowledgment from abroad of Chinese reform efforts.

“China will need to keep working on making its financial markets more open and that includes giving more access to foreign investors and addressing fears over capital controls,” the Australian Financial Review’s Philip Baker said. “At the moment policymakers seem intent on keeping their grip on the yuan so it implies they are in no hurry.”

Yet China’s central bank chief has openly called for further reforms, despite moves by policymakers to stem capital outflows.

“Some individuals say we should protect and safeguard the financial sector until it can become more developed and robust,” People’s Bank of China governor Zhou Xiaochuan said Tuesday. “The experience from overseas and here shows that protection only leads to inertia, lack of regulation, and rent-seeking.”

For China’s reformers, MSCI’s decision has given a $340 billion incentive for further openness as it seeks to expand its economic influence internationally. The test for Beijing however will be how it responds to the next market downturn, either through intervention or allowing market forces to take control.