Remember when you were back in school playing team sports? Before playing a match you’d have to pick teams. First, one team captain chooses, then the other captain, and back and forth they go.
Usually, the last person left at the end would be the weakest player, the slowest, the guy (or girl) with two left feet.
When it comes to the MSCI, the world’s stock market index team-picker, the players (country stock markets, that is) have all been picked – but the second-biggest player is still sitting on the bench.
MSCI leaves (part of) China on the bench
When it comes to emerging markets, China’s stock market is – or should be – one of the best players on the pitch. It has a market worth about $7 trillion and accounts for around 10 percent of total global stock market value. In fact, as we’ve written before, China is now so big that it shouldn’t be called an emerging market at all – it’s very much emerged.
So it looks odd that China’s main stock markets are not part of the world’s biggest stock market indexes. It’s not picked last… not even picked at all to play for a team.
MSCI is the world’s most influential index provider. Its decisions influence trillions of dollars of trading in the stock market. Fund managers and investors use it as a benchmark to build emerging-market portfolios.
In 1998, MSCI launched an emerging markets index to measure stock market performance in emerging markets around the world. It started with just 10 countries. Today, 23 countries are part of it.
About $1.5 trillion of investment funds track the MSCI Emerging Markets Index. So when MSCI adds or removes stocks or countries from its index, it makes a big difference to share prices. That’s because the mountains of money that “follow” the index – such as the iShares MSCI Emerging Markets Fund (NYSE; ticker: EEM), which holds $30 billion in total assets – has to adjust its investments to track MSCI’s changes.
The MSCI Emerging Markets Index already includes a lot of China. At the start of 2016, China had the largest slice of the index at 24 percent. But these shares are either Hong Kong-listed H shares (the Hong Kong-listed shares of Chinese companies) or shares of Chinese companies listed on U.S. exchanges. None of them are A shares trading on a mainland China exchange (we’ve written about this before here and here.)
So Chinese shares traded in China – the world’s second-largest economy (in terms of combined value) with the world’s second-largest stock market – are not reflected in the major market indices, like the Emerging Markets Index… or in other regional and global MSCI indices. Yet.
Why are A shares left off the team?
MSCI has had a lot of reasons to exclude China’s A shares, not just from the Emerging Markets Index, but all its indices.
For starters, it’s difficult for foreign investors to trade A shares. It’s much easier just to buy Chinese shares on the Hong Kong exchange. The Chinese government has also imposed quotas restricting how much money foreign investors can invest in mainland China shares.
The Chinese authorities haven’t done themselves any favours, either. In the summer of 2015, China’s benchmark Shanghai Composite Index plunged 43 percent from June to August, as shown in the graph below. The government stepped in to stop the slide, suspending trading and changing some of the market rules. This direct state involvement spooked some investors. Others worried it would be impossible to get their cash out of China in the event of another crash, as we wrote early last year.
Last year, MSCI cited three obstacles to including mainland China shares in the MSCI Emerging Markets Index…
- Global institutions offering investment products linked to mainland Chinese shares must first get approval from Chinese exchanges.
- Investors can’t take more than 20 percent of their investment out of China in a single month – known as the Qualified Foreign Institutional Investors (QFII) quota.
- The number of trading suspensions, which MSCI described as “the highest in the world.”
In other words, despite positive moves toward liberalising China’s market, it has been considered too restrictive to be included in MSCI’s indices… for now.
So… what’s changed?
The Chinese government has tried to address some of these issues. It linked the Hong Kong and Shanghai stock exchanges in 2014 to increase the number of A shares that international investors can trade. Last December, it launched the Shenzhen-Hong Kong Stock Connect program to give investors access to nearly 1,500 companies listed on China’s second-biggest stock market. Investors using these programmes do not need a license and are not subject to quotas. This is another important step in the liberalisation of Chinese markets, as we’ve written before.
Linking Shanghai and Shenzhen to the Hong Kong stock exchange enabled investors to trade shares on both markets. It also removed some of the barriers to investment that had prevented mainland China shares being included in MSCI’s indices in the past. On top of this, new trading suspension rules have greatly reduced the number of suspensions in trading.
But this liberalisation has limits. International companies still need the approval of Chinese exchanges before offering products linked to mainland shares, and the 20 percent QFII repatriation quota is still in place.
What’s new now?
MSCI is now consulting investors again, but with a more limited scope. In the consultation document released last month, MSCI is proposing to reduce the number of stocks considered for inclusion in the Emerging Markets Index to 169 (from 448 in 2016.) These 169 stocks are all available through the Shanghai and Shenzhen Connect programmes.
The new proposals suggest that A shares would form just 0.5 percent of the index – half of what was proposed by MSCI a year earlier. MSCI is also proposing to use the offshore yuan for index calculation, rather than its onshore equivalent. The offshore yuan is more independent of China’s central bank, which makes it more attractive to investors.
Lastly, the consultation proposes not including stocks that have experienced extended trading suspensions (or long run halts) and dual-listed A shares in the index.
What happens next?
China will begin to address these issues over the next few weeks. But we’re already seeing some positive signs.
The Chinese government has signaled that it will remove or amend the trading halt rules as well as the quota for traders using the Shenzhen-Hong Kong Connect program.
If MSCI decides to go ahead with its inclusion plans in the future, it could mean a major boost for mainland Chinese shares in the long-term. The decision on whether to include A shares in 2018 will be announced this June. These kinds of seismic changes in indexes rarely occur. The potential impacts are enormous. I’ll keep you posted as Chinese authorities cross off MSCI concerns.