China’s growing acceptance into international capital markets faces a watershed moment next week with a decision on whether a first batch of stocks listed on its $7tn domestic equity markets will be included into the world’s dominant emerging markets stock index.
If MSCI, an index provider, approves the inclusion of a cohort of Shanghai and Shenzhen-listed A-shares into its main emerging markets index, it will confer an unprecedented recognition upon China’s domestic capital markets and oblige funds all over the world to pour billions into the country’s stocks.
Although mainland-listed Chinese stocks and bonds have already been included in several investment sub-indices, they have yet to ascend into an international benchmark index. The distinction is crucial because fund managers judge their performance against benchmarks, so inclusion obliges them to buy the underlying securities.
“To sum this up in one word, I would say it is monumental,” says Caroline Owen, chief executive of RMB Global Advisors, a New York-based advisory firm. “We are on the verge of one of the greatest rebalancings of global portfolios that we have seen in recent years.”
Currently, China’s A-share markets and its $9.3tn domestic bond market — which rank as the world’s second and third largest respectively — remain largely sequestered from international capital flows because governance problems dissuade index providers from including them in their benchmarks.
Opinion is divided, however, on whether MSCI will next week grant inclusion to A-shares. In each of the last three years, the company has debated inclusion among its clients only to reject it, citing market access obstacles and governance issues.
This year, though, MSCI sharply pared back its inclusion proposal to make it more palatable to its clients. It cut the list of stocks to be included in the benchmark index to 169 from 448 previously, meaning that if A-shares win entry they will account for just 0.5 per cent of the MSCI EM Index, down from 5 per cent under the previous proposal.
The index provider also effectively dropped a market access objection that related to the Qualified Foreign Institutional Investor scheme. This channel allows approved foreign funds access to A-shares but under conditions that limit their ability to repatriate their money — an issue flagged by MSCI last year when it rejected the inclusion of A shares.
Earlier this year, MSCI focused on Stock Connect, a parallel system between Hong Kong and mainland equity markets that provides access to domestic shares with fewer repatriation limits.
To some, such accommodation smacks of expedience.
“The US firm [MSCI] has resolutely rejected inclusion . . . citing prevailing concerns over the inability to access, trade and cash in stocks freely,” says Nick Yeo, head of Chinese and Hong Kong equities at Aberdeen Asset Management.
“But we detect a marked change in MSCI’s accommodation this year,” Mr Yeo adds. “Far from endorsing Beijing’s efforts to address previous impediments surrounding ownership rights, capital repatriation limits and trading suspensions, the index creator has instead modified its own admission criteria to such a degree that China’s entry now appears a formality.”
BlackRock, the world’s largest asset manager, said in April for the first time that it backed the inclusion of domestic Chinese shares in the MSCI’s global indices.
Fidelity, another large investor, also strikes an upbeat tone. In a statement provided to the Financial Times, Tim Orchard, chief investment officer in the Asia Pacific (ex-Japan), says: “As access to China’s onshore equity market widens, it is natural for these stocks to be gradually included in equity market indices.”
Such alacrity to embrace China’s domestic stocks comes amid stiff competition from MSCI’s rivals. Vanguard, one of the world’s largest asset managers, offers a successful emerging markets exchange-traded fund which follows a China A-share sub-index provided by FTSE, a competitor to MSCI.
“The fact that Vanguard decided to track our index shows that they know A-share inclusion into the FTSE benchmark index is going to happen,” says a spokesperson for FTSE. The index provider is set to review its indices in September.
In further signs of MSCI’s efforts, it whittled down the 169 stocks it is proposing for inclusion by barring companies that have been suspended from trading for more than 50 days, as well as those that do not have sufficiently large capitalisations. They also adjusted the weightings to reflect investor preferences for consumer stocks over financials (See chart).
The bottom line for MSCI, says Mr Yeo, is that if their clients do not vote for inclusion, they risk missing out on the good returns that A-shares can offer. “If they are late to the point of losing relevance to investors, then inclusion could become more urgent,” he says.
MSCI declined all comment on questions surrounding A-share inclusion. Currently, investors who track the MSCI EM Index do already get considerable exposure to Chinese companies that are listed beyond mainland China, mainly in Hong Kong. These type of listings account for 28.1 per cent of the MSCI EM Index and 3.1 per cent of the MSCI All-Country World Index.
In other key decisions from MSCI next week, Argentina may move from being a big fish in the frontier index to a small sprat in the emerging market ocean. It has 14 stocks in MSCI’s FM100 index, more than any other country, and an index weight of 19.5 per cent, second only to Kuwait. Nine of those stocks would make it into the EM index, leaving Argentina with a weight of just 0.4 per cent.
That would come when there is a lot more money available for investing in Argentina. Analysts at Goldman Sachs wrote in a report this week that “the aggregate pocket of investors eligible to trade Argentine equities” could increase by about five times. All else being equal, they estimate that promotion to EM status would boost Argentine share prices by between 8 and 15 per cent.
Nigeria, meanwhile, is waiting to see if it will be dropped out of the frontier index, with some analysts saying that recent moves by the government to free up foreign exchange markets for investors may convince MSCI to stay its hand.