China misses out again

Stephen Mulrenan

The inclusion of China’s domestic shares on the widely followed MSCI index for emerging markets has been rejected again. The delay is likely to continue until the country pushes through capital markets reforms and is more transparent.

China has been seeking in vain to have its domestic shares – otherwise known as A shares – recognised internationally since 2014. On 14 June 2016, the world’s largest stock index provider announced that it would delay for the third year in succession the inclusion of China A shares in its emerging markets index.

In justifying its decision, New York’s Morgan Stanley Capital International (MSCI) stated that China’s capital market is still not sufficiently accessible for international investors: there remain too many restrictions, such as foreign access to A shares still being limited to narrow channels like the Qualified Foreign Institutional Investor (QFII) programme.

‘The inclusion of China’s A shares was expected to attract billions of dollars into China’s stock market in this downward economy,’ explains Caroline Berube, Co-Chair of the IBA Asia Pacific Regional Forum and partner at HJM Asia Law. ‘Due to the delay, short-term enthusiasm to invest in the mainland is dwindling and delays long-term opportunities and interest in the foreign capital. It’s a huge setback,’ she adds.

MSCI’s next index review will be in June 2017, although the company has not ruled out a potential off-cycle announcement if remaining concerns are adequately addressed beforehand.

Towards inclusion

Approximately US$1.7tn of assets from global fund managers, institutional investors and pension funds track the MSCI emerging markets index. Inclusion would likely have brought an additional US$30bn into the
A-share market in the short term, and perhaps as much as US$400bn in the longer term, according to a recent report by HSBC.

Qatar and the United Arab Emirates were the last two emerging markets to be included in the MSCI index, bringing the total number to 23. Like China, Qatar and the UAE are markets with limited research coverage, and index inclusion has helped to boost liquidity as a result of more information being made available to foreign investors.

The China Securities Regulatory Commission stated before the MSCI decision that global indices would be ‘incomplete’ without mainland-listed shares. Beijing’s recent eagerness to accelerate the internationalisation of its stock market is due in part to the collapse in mainland share prices over the last year. The Shanghai Composite has tumbled 43 per cent to be the worst performer among global gauges.

Mainland officials struggled to halt a US$5tn sell-off in 2015, during which the Shanghai and Shenzhen exchanges permitted trading suspensions that shut down half the stock market. In a determined effort to be included in the MSCI index, Chinese authorities introduced a spate of measures earlier this year to address remaining concerns, including curbs on arbitrary trading halts and looser restrictions on cross-border capital flows.

Such efforts were acknowledged by MSCI in its June ruling. ‘They demonstrate a clear commitment by the Chinese authorities to bring the accessibility of the China A shares market closer to international standards,’ said Remy Briand, Managing Director and Global Head of Research. ‘We look forward to the continuation of policy momentum in addressing the remaining accessibility issues.’

In its reviews in 2014 and 2015, MSCI cited limited foreign access and a lack of transparency in the market as serious impediments to China’s inclusion in the index. Commenting on its most recent criteria for inclusion, MSCI said that only issues regarding beneficial ownership had been satisfactorily resolved. The other four major limits on the launch of A share-linked financial products – the quota allocation process, capital mobility restrictions, widespread voluntary suspension, and pre-approval requirements imposed by stock exchanges – still needed addressing.

In addition, since an announcement on 27 May 2016 of enhanced regulations on trading suspension – cited by investors as the most critical issue that needed resolving – investors have called for greater clarity and a period of observation to assess their effectiveness.

Finally, on concerns around capital outflows, investors have called for more time to assess the effectiveness of QFII policy changes aimed at addressing quota allocation and capital mobility restrictions.

In his statement, Briand concluded: ‘International institutional investors clearly indicated that they would like to see further improvements… before its inclusion in the MSCI emerging markets index. In keeping with its standard practice, MSCI will monitor the implementation of the recently announced policy changes and seek feedback from market participants.’

Reforms and transparency

Following the MSCI ruling, Shenzhen stocks rallied on speculation that the Chinese authorities could expedite an exchange link with Hong Kong. More specifically, there were expectations that the pace of the Shenzhen link will now be accelerated to offset the negative impact of the MSCI decision, as well as to display China’s commitment to further opening up its capital markets.

Many commentators hope the MSCI rejection will encourage Beijing to continue its reform plans to open up its capital market further. However, if reform requirements relate to transparency, then this may not happen any time soon, says Graham Wladimiroff, the Shanghai-based Assistant General Counsel at AkzoNobel and Corporate Counsel Forum Liaison Officer for the IBA Asia Pacific Regional Forum.
‘China will continue to seek other ways to maintain information and financial control while still attracting funds,’ he explains.

Yet many analysts argue that the Chinese authorities must be more transparent and timely with announcements if they expect to see A shares included in MSCI indices. Indeed, China need look no further than to neighbour South Korea to gain an understanding of the long-term benefits of MSCI inclusion.

South Korea has been a constituent of the index for two decades, but it took six years to secure full inclusion, from an initial
20 per cent in 1992. Notably, the process ran parallel with the country’s regulatory efforts to release capital controls.

Like China, South Korea had strong retail participation in its market prior to inclusion in the index, after which there was greater interest from international investors. For example, foreign capital made up 18.5 per cent of its stock market in 1999, compared to 30 per cent today, while retail investors contributed 31.7 per cent in 1999, compared to just 23.6 per cent today.

Although foreign direct investment had become less essential to China, Wladimiroff says it is now more important again because of the slowdown in growth and the huge debt levels, particularly at regional and local government level.

‘It is important to keep in mind though that it is not China’s objective to become a market economy,’ he says. ‘There is no strategy to gradually introduce what is required for a successful market economy including developed capital markets. The main objective will be attracting funds and encouraging development, but not transparency.’

He adds: ‘Shares in Chinese entities are notoriously difficult to value, as “transparency” is not an objective at a national level. Therefore, as long as government and listed companies in China do not see or want to see the critical importance of transparency, the inclusion of domestic shares in any index of standing will be a struggle.’

In the meantime

That said, given the size of China’s stock market and the country’s economic influence, many commentators believe it is only a matter of time before China’s A-share market is included in MSCI indices. Until then, it has been suggested that Hong Kong could be the main beneficiary of the MSCI decision, given that institutional investors can continue to buy H shares listed in Hong Kong as a proxy to investing in China.

‘The Hong Kong stock is definitely benefitting from this decision as it means that investors interested in buying A shares are not yet getting rid of their H shares,’ says Berube. She adds that only a limited global impact is likely to be felt, ‘due to the typical domination of China’s A shares by local investors, preventing the inclusion/ exclusion to have a significant impact on foreign investors’.

However, although investment funds are willing to take greater risks during times when returns are difficult to come by, Wladimiroff says: ‘[Investing in proxies] creates the impression of transparency, but the underlying information remains of poor quality. Hong Kong may be the beneficiary, but if the investment turns out to have been based on false or misrepresented figures, then in due course the Hong Kong listing will not protect the investment.’

Stephen Mulrenanis managing editor of Compliance  Insider at Compliance Publishing Group. He can be contacted at stephen.mulrenan@complianceinsider.com