Index giant MSCI, which leads the benchmarked emerging market equity competition with a reported $1.5 trillion in assets, again passed on adding Chinese A shares to the main universe. Pakistan returned to that status, and no action was taken on Peru after signaling possible demotion to frontier market membership.
China’s currency and stock exchange immediately dived on the news, as performance and trading volume jumped for the other two. The “MSCI effect” is familiar and last centered on Mideast components in 2014, when the UAE and Qatar rallied to records in graduation anticipation.
They have since corrected, as investors looked beyond the index skew to economic and financial system health and company earnings and valuations. Chinese officials lobbied for A share inclusion and introduced a wave of rule changes before the announcement, as they tried to safeguard prestige and avoid the overnight carnage from rejection. However the best near-term scenario, still not ruled out by MSCI, for marginal insertion phased in next year still doesn’t change the underlying unfavorable financial market calculus. The rival FTSE series may soon endorse the index joining in its own review. But only more thorough banking and securities industry modernization will restore lasting portfolio inflows.
Obstacle course
MSCI cited well-known obstacles for its deferral, despite progress since consideration a year ago and China’s massive trading halt and intervention with last summer’s subsequent yuan devaluation. Investment quotas impede standard emerging market fund mobility, with repatriation capped at 20% of net asset value for the QFII scheme. Account beneficial ownership was masked until recent clarifications, and the Shanghai Stock Exchange also released new guidelines for individual listing activity suspension, but both have yet to be tested in practice against continuing access and custody limits.
Regulators maintain sweeping pre-approval powers for ETFs and other products routinely allowed elsewhere, including short sale vehicles. The index sponsor called their scope “unique in emerging markets,” and also pointed to delays in new IPO rules and other areas for the thumbs down. The Chinese delegation at last week’s Strategic and Economic Dialogue must have sensed the narrow window, as it offered the US a surprise $50 billion RQFII offshore yuan quota in a likely bid to sway the verdict.
The IMF expressed parallel reservations as Deputy Managing Director David Lipton led an Article IV mission to Beijing and urged “imperative action” to repair debt and financial market vulnerabilities. He emphasized that corporate debt at almost 150% of GDP was still growing, with state-owned firms accounting for over half the total “without a hard budget constraint.” Equity and currency dealing distortions may erode shock buffers over time, the Fund cautioned. FDI fell 1% in May on an annual basis and fixed-investment as the domestic economic linchpin rose less than 10% from January-May for the slowest pace in fifteen years. In a separate report Goldman Sachs found that first quarter A share profits were flat, underscoring negative securities market trends.
Pakistan stocks rally
Pakistan stocks spurted 3% in contrast after the MSCI core tier reinstallation, extending a double-digit rally as Asia’s best local index performer. The frontier demotion came in the post-2008 crisis aftermath when the exchange imposed a loss floor which shut it for months. An estimated $200-300 million may flow into the market through 2017 with the upgrade, although it will be a paltry 0.2% of the overall emerging market gauge. The bourse demutualized over its spurned period with private investor opening, and liquidity and turnover have picked up with economic strides under Prime Minister Nawaz Sharif, including successful completion of a $6 billion IMF program, bank and utility privatizations, and energy sector reform despite lingering corruption and security threats.
Peru was due for the opposite move, a drop from the main to frontier index, but forestalled it with an intensive international public relations campaign, capital gains tax holiday, and promise to increase eligible listings beyond the current two miners and one bank. Former fund manager Pedro Pablo Kuczynski has just been elected president on a free-market, TPP passage, and inclusive financial system platform. His background and policies can help solidify index and investor retention, in a more durable weighting shift than benchmark formula revamp.
Gary N. Kleiman is an emerging markets specialist who runs Kleiman International in Washington, D.C.