MSCI Emerging Markets Index: Perspectives for China

In mid-June, MSCI announced that the shares of 222 Chinese companies – the A-shares – would be progressively added to its Emerging Market Index. Those companies which include the Bank of China, Ping An Insurance, China Merchants Bank, or the Tsingtao Brewery are amongst the 448 biggest companies in China as listed in the MSCI China A International Index.

Why is that worth talking about?

MSCI’s decision is significant because it broke with a negative trend which for several years had seen Chinese A-shares excluded from global capital markets. To some extent, at least.

The Index provider began considering including mainland stocks to its indexes from 2014, but until now it always decided not to because it thought that China’s capital markets were too weak to match international financial standards.

In June 2016, MSCI cited three obstacles to the inclusion of Chinese A-shares in the emerging markets index. One was the lack of ‘effective implementation of the QFII policy changes’ – the Qualified Foreign Investors programme put in place in China to control foreign capital investments on domestic markets – and the capping of fund repatriation to a 20% monthly limit. A second obstacle related to the inability of the Chinese financial regulator to manage trading suspension mechanisms. A third obstacle related to overly constraining pre-approval requirements by the local exchanges in relation to the launching of new financial products linked to China A-shares.

Over the year 2016, as a reminder, the Chinese regulator’s management of the domestic capital markets had raised eyebrows. The speculation-fuelled crash of 2016 generated important trade suspensions of the summer (as noted by MSCI, the number of trading suspensions in the China A-shares market remained by far the highest in the world with more than 100 names being impacted, representing 5.3% of the MSCI China A international IMI Index weight) and the handling of the short-lived Circuit Breaker was largely criticised (see the FT RIP note here).

Hence, MSCI regularly refused to include Chinese A-shares in its Emerging Markets Index over three years because of a lack of clarity, transparency and efficiency in the domestic capital markets system.

The 2017 developments

In May 2017, MSCI launched an ‘internal consultation’ with the aim of determining whether the A-shares were deemed ‘investable’. The consultation asked three questions, the first and main one being formulated as follows:

“Given the current degree of market development and various accessibility channels that are now available, would international institutional investors consider China A-shares, or a subset of the A-shares opportunity set, investable?” (emphasis added).

Overall, while the restrictions on the 20% QFII repatriation imposed on foreign capital investors and the limits placed on A-share financial products had remained unchanged, an important factor emerged as a game changer contrasting with the previous years: the Shanghai Shenzhen Connect Scheme launched in December 2016 with the aim of enabling foreign investors to access approximately 1,480 Shanghai and Shenzhen stocks without needing to apply for a license and quota and subject to capital mobility restrictions.

Hence, MSCI considered whether the Connect scheme would have an impact in terms of market accessibility, questioned the “unique investability challenges linked to the daily limit and additional market holidays” and, even more importantly, asked whether “the potential 5% inclusion [of A-shares in the index ought to] be linked to broader improvements in all access channels (QFII, RQFII and Connect)?”. Or, in other words, could inclusion lead to financial reform in the future?

Room for change

MSCI’s June 2017 decision to include the Mainland A-shares into its Emerging Market Index provided some answers to these questions.

On the one hand, the inclusion of Chinese A-shares in the Emerging Markets Index sent the message that the Shenzhen Scheme was indeed to be interpreted as a positive financial openness indicator. Or, as summarised by a financial commentator, “Chinese-listed shares have what it takes to be included in global indexes like accessibility, liquidity, and transparent ownership”.

On the other hand, MSCI’s move largely insists that significant efforts remain to be done on the “broader improvements” side of things. By implementing the hypothetical “5% inclusion” of A-shares in the Index, MSCI significantly reduces the weighting of each stock on the index to 5% of its actual market capitalization. In other words, MSCI adds Chinese A-shares to its index, but only to a very limited extent (5% of their worth), and makes sure that the initial weighting of Mainland China’s stocks is drastically limited until more progress is made.

In other words, the A-share are investable, but there is a lot more to be done before they can be considered reliable.

Impact for Beijing

The MSCI inclusion will have an impact on Beijing, but it is likely to be political rather than financial at this stage.

Financial Perspective

From a financial perspective, the impact of the inclusion will remain limited. Of course, because the MSCI Emerging Markets Index is tracked by important funds the Chinese A-shares will now be traded globally and accordingly benefit from cash flows originating from those funds.

Yet, the inclusion does not mean that the Chinese A-shares will receive tremendous interest in the short term. First, the weighting of Chinese A-shares is as just mentioned largely limited to 5% of their actual capitalization. Second, the Chinese A-shares will only be allocated approximately 0.73% of the weight of the MSCI Emerging Markets Index so that they will overall remain marginal in comparison with the whole index. Third, the MSCI Emerging Markets Index is not the only available option for getting access to the A-shares since, as mentioned before, foreign investors already have (relative) access to Chinese shares through the recent Shenzhen Stock Connect. Not to forget, of course, the possibility to access Hong Kong dually listed Chinese stocks.

In other words, while China has the world’s second-biggest stock market (after the US), the MSCI listing would appear as an additional entry point for investors but its financial impact will remain limited for Chinese companies.

Political Perspective

From a political perspective, however, the MSCI inclusion is very significant for Beijing because it sends the message that the Chinese regulator is indeed making progress on the financial governance side of things.

Over the past years, the Chinese A-shares’ inclusion into the Emerging Markets Index had failed repeatedly because of a lack of trust in Chinese financial regulations and institutions.

Beijing, nonetheless, has been making efforts over the past years to develop the RMB as an international (and internationalized) currency, to open its financial markets and to attract stock and bond capital investors through various schemes (read also: What is the Hong Kong – China Bond Connect about?).

Hence, this development acknowledges progress, enacts relative improvements in terms of foreign investment accessibility and trust, and has been described as “ a stamp of financial credibility” by foreign financial commentators while financiers described the inclusion “as an important milestone in the integration of China’s equity markets with the rest of the world” (Bloomberg, 20/06/2017).

Concluding remarks: More work to be done

If the Index inclusion is a good political sign for Beijing, work however remains to be done and, interestingly, MSCI might now be in a strong position to further influence the development of Chinese capital markets.

Bluntly, CNBC described this as a carrot and stick move and there is no point to try formulating things more intelligibly: “the company is smartly holding out a carrot to the Chinese regulators: Do more to open-up your markets, and we will include more of your stocks. That’s a big carrot: Chinese authorities desperately want their markets to be more widely owned outside the country” (CNBC, 21/06/2017).

The expectations here would logically flow from the above. Less interference from the regulator, fewer limits on profit repatriation, fewer quotas on investment, and more efficiency in the Connect schemes. At stake, an extension of the 5% weighting cap to 100%, and the possible inclusion of more companies into the index. In the long term, in fact, some experts suggest that the Chinese A-share might represent nearly 15% of the MSCI Emerging Markets Index against 0.73% now. Quite an incentive…

For Beijing, therefore, the MSCI is both a milestone in terms of the progress made so far and an opportunity to further China’s integration into global capital markets and into the global financial system more generally. A question therefore remains: will more reforms take place?