China misses out on MSCI Emerging Markets index

New York index provider surprises analysts with negative decision but stocks close at highs amid optimism over exchange link with Hong Kong.

BEIJING // The MSCI, the New York-based stock index provider, has refused to accept mainland Chinese shares in its Emerging Markets Index, but promised to review the situation in 2017.

It also pledged a mid-year review if China is able to carry out some market reforms that it has flagged in its judgment.

However, China’s stock markets shrugged off the decision to close up after an earlier slide, although the MSCI verdict did result in a sharp response from the Chinese markets regulator, which said that the index itself is “not complete” if it ignores stocks from the world’s second-biggest economy. The debate intensified yesterday as the MSCI issued another statement explaining why it had decided against the Chinese listing.

“China is now the world’s second-largest economy. The influence of A-shares is on a rising trend gradually in the international markets. Any international index which does not include the A-shares is not complete.” said Deng Ge, a spokesman for the China securities and regulatory commission.

The negative MSCI decision comes despite the IMF recently agreing to include the yuan as one of the currencies in its basket for Special Drawing Rights. Strategists at Goldman Sachs and Citigroup said on Wednesday they were surprised at the index provider’s decision. Goldman Sachs had put the chance of approval at 70 per cent.

“It’s definitely a disappointment,” said Kinger Lau, a Hong Kong-based strategist at the bank. “I had pretty high expectations because the direction in terms of how the Chinese government has addressed concerns raised by MSCI was very positive.”

Concerns over whether the MSCI rejection would affect China’s image in world financial markets and hurt attempts by Chinese companies to float shares and bonds in international markets have been overplayed, economists said.

Oliver Rui, a professor of finance at the China Europe International Business School said there would be little impact because the MSCI was planning to list A shares of Chinese companies, which are in any case off-limits for foreign investors.

"Inclusion in MSCI has limited impact because the A-share market is dominated by local investors," Mr Rui told The National.

He agreed with the Chinese regulator, however, saying, “China is the world’s second-largest economy. Without the A shares, a significant portion of stocks are not included in MSCI’s emerging market index”.

Explaining why it has not included Chinese shares in its index, Dimitris Melas, the MSCI managing director and global head of equity research said: “International institutional investors clearly indicated that they would like to see further improvements in the accessibility of the China A-shares market before its inclusion in the MSCI Emerging Markets Index”.

At the same time, MSCI praised China’s efforts at market reforms saying that “there have been significant steps toward the eventual inclusion of China A shares in the MSCI Emerging Markets Index.”

MSCI said it gathered feedback from market participants on the potential inclusion of the A-shares in the index.

"I think the MSCI's decision primarily reflects the fact the financial reforms in China haven't yet gone far enough rather than worries that policymakers will back-track on already implemented reforms," Chang Liu, the China economist with Capital Economics told The National.

China need not lose heart. The MSCI said that it would consider including the yuan denominated A-shares as part of its next market classification review in 2017. It wwill monitor the implementation of recently announced policy changes and will seek feedback from market participants.

In effect, The MSCI’s rejection means A-shares would not be part of its Emerging Market Index of the overall index which is used by assets worth $1.5 trillion globally as an important benchmark. The index works as a bellwether for asset managers, pension funds, insurers and individual investors hold passive investments like an exchange-traded fund (ETF) or mutual funds.

The MSCI cited two reasons why it did not enlist the Chinese stocks. One of them is China’s decision to impose a 20 per cent limit repatriation of funds by foreign investors during share sell-offs. The global compiler also called for removal of the Chinese rule that allows local exchanges in Shanghai and Shenzhen to impose pre-approval restrictions on launching financial products.

China’s stock markets were hit late last year when valuations plunged about 40 per cent. About half of Chinese listed companies responded by voluntarily suspending their trading. Some extended that halt in trading for months to avoid the volatility of the market

Despite the MSCI pressure, China is unlikely to meet these demands for rule changes even if it means the index maker would not implement mid-year review as it has indicated.

“Removing the 20 per cent monthly repatriation limit and the local exchanges’ pre-approval restrictions could increase the volatility of RMB [yuan] and the stock market,” said Mr Rui. For China “the stability of the RMB and stock market is more important” than MSCI listing, he said.

At present, Chinese stocks make up for only about one-fourth of the Emerging Markets Index of MSCI although it is the biggest economy in the emerging markets and the second biggest in the world. If the global compiler had agreed to include China’s A shares, it would have pushed up the ratio to one-third and resulted in a reduction of the influence of stocks from other countries in the emerging markets.

The Chinese regulator has said it would continue on the path of market reforms for its own sake regardless of the decision.

“While the MSCI decided to delay A-shares in its emerging market indices, this would not affect the progress of China’s capital market reform plans to develop a more market-oriented and properly regulated market. Establishing long-term stable and a healthy capital market is in line with our needs,” Mr Deng said.

Mr Chang says the MSCI decision should not been seen as a rejection.

“Both MSCI and China’s policymakers are working to get A-shares included the MSCI’s equity indices. After all, China’s stock markets are now among the biggest in the world,” he said.

“That said, there are many regulatory issues that still need to dealt with. In particular, MSCI seem to be concerned about restrictions on the movement of capital in and out of China.”

Mr Chang expects the Chinese regulator “would continue to push through reforms to address concerns that MSCI have brought up – just like they have been doing in the past”. At the same time, one should not expect any drastic changes from Chinese policymakers, he said.

One issue that may have influenced the MSCI and its advisors during the decision making process on is that adding Chinese shares to the EMI would have resulted in a significant reduction in the weighting of stocks from other Asian and Latin American countries including India, Morgan Stanley predicted.

It would have also reduced the valuations of companies in the other Asian countries making them vulnerable for takeovers by cash-rich companies including those in the western world and China, analysts said.

Despite the refusal, China’s stock market rose the most in two weeks on Wednesday, reversing from early losses as investors shrugged off the MSCI’s decision.

Traders said investors had already been bracing for a “no” decision, as reflected by Monday’s market tumble of more than 3 per cent, with some bargain hunting in the process.

The blue-chip CSI300 index rose 1.3 percent, to 3,116.37, while the Shanghai Composite Index gained 1.6 percent, to 2,887.21 points.

They had opened about 1 per cent lower as some investors who had clung on to hopes of MSCI inclusion unwound their bets. The Shanghai Composite Index rose 1.6 per cent at the close after falling as much as 1.1 per cent, with about 88 shares gaining for each one that dropped. A measure of Shenzhen stocks rallied the most this month on speculation authorities could expedite an exchange link with Hong Kong after the MSCI’s decision. The Hang Seng China Enterprises Index added 0.3 per cent. China’s onshore currency added 0.1 per cent after sliding to a five-year low.

“It’s a sharp reversal so there has to be some government intervention,” Francis Lun, the chief executive at Geo Securities in Hong Kong. “The Chinese government never wants to see the market falling too much.”

The Shenzhen Composite Index surged 3.1 per cent and the ChiNext gauge of small-company shares rallied 3.4 per cent, bolstered by speculation authorities will announce a start date to the long-delayed exchange link with Hong Kong.

“There are expectations that the pace of the Shenzhen link will be accelerated to offset the negative impact of the MSCI decision and to display China’s commitment to further opening up its capital markets,” Wang Chen, a partner with Xufunds Investment Management in Shanghai.

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