NEW YORK–In what must feel like an epic smack down, MSCI denied China’s domestic equities entry into its benchmark indexes for the third time in as many years.
Not that it should have been a big surprise. After a year in which the mainland market, known as the A shares, surged 150% to record highs, suffered a crash knocking off 40% and suffered through a comically ineffective campaign to prop up share prices showing that the regulators had no idea what they were doing, it’s lucky it got this far.
Late Tuesday, the New York-based index company said it would delay the inclusion of the China A Shares in the MSCI Emerging Markets Index. The news was a big setback to President Xi Jumping’s efforts to raise the profile of the mainland markets. With more than $1.5 trillion in assets tracking it, this index is the premier global benchmark for equities from the emerging markets.
And if the yuan-denominated shares do join the widely-used index, it could bring $400 billion into the mainland market over the next decade, according to MSCI.
Reforms came too late
“There have been significant improvements made by the Chinese authorities to improve the A share market for investors,” said Remy Briand, MSCI managing director and global head of research, during Tuesday’s conference call. “But, some of of them are relatively recent, so we need a little bit of time to assess the effectiveness of these measures.”
And it must have been adding insult to injury when Briand announced that the MSCI Pakistan Index would be receiving emerging market status, while the A shares would not.
MSCI said the A shares had three big obstacles they needed to hurdle before it would feel comfortable bringing them into the big leagues. The first is the effectiveness of the QFII policy changes affecting accessibility and capital mobility. The second is the implementation of measures to prevent the widespread voluntary suspension of stock trading in Chinese companies, and finally, the pre-approval requirements imposed by local Chinese stock exchanges.
“What needs to be very well understood is this isn’t an MSCI problem,” said Briand. “It’s a market accessibility problem.”
He said international investors are used to creating any product they want on any exchange around the world. All they need to do is comply with local regulations.
“But, all the existing products on emerging markets would be in breach if we include the A share market,” he said. “You would not want to put all these products at risk.”
Consulted with asset managers
Briand said MSCI held consultations with asset managers of all types and with various securities authorities all over the globe.
“It’s a consultation process, not a voting process,” he said. “We are most interested in the opinions of investors in accessing markets. They make views on suitability.” He declined to name any of the individual entities that were consulted, but said it was a representational cross section of large institutions worldwide.
He said the feedback received from the investors was that they found the three main obstacles highly problematic to doing business on the mainland.
In particular, investors found the effective implementation of the QFII policy change limiting the monthly repatriation for investors to just 20% the prior-year net asset value to be highly problematic. Both pension and mutual funds were very concerned that the 20% limit would cause liquidity problems and hurt their ability to honor huge redemption outflows from their clients.
Investors also didn’t like the broad pre-approval restrictions imposed by the Shanghai and Shenzhen stock exchanges. The restrictions related to the launching of financial products linked to indexes that include China A shares by any financial institution on any international stock exchange.
Briand said all the products that currently exist on the emerging markets would be subject to breaching this pre-approval. The global investors considered this a big risk that they refused to deal with. They demanded that the removal of the pre-approval was necessary for the A shares inclusions.
Trading suspensions hurt most
But the biggest issue upsetting the global investors was the ability of authorities to suspend trading in any and all companies.
Briand said if you look at the universe of equity shares suspended throughout the world, 90% were A shares and that this was a very disturbing and problematic situation that was not in the interests of international investors. He said there would need to be a significant reduction in the suspended shares on both the Shanghai and Shenzhen markets before China would enter index. Briand declined to give a specific number of suspensions that needed to be lifted.
Briand did say MSCI had held extensive talks with the Chinese securities regulators and that much positive momentum had been achieved since February, when Liu Shiyu took over as the new chairman of the China Securities Regulatory Commission’s (CSRC).
Announcement before next June?
Briand declined to say how much time was needed for China to resolve these problems, but “What is very clear is that there has been a lot of momentum in terms of implementations by the authorities, a lot of positive momentum in recent months.”
He said it was hard to assess how long MSCI would need to assess the markets, but if the issues were resolved quickly the index company wouldn’t need to wait until next June to announce that the A shares would be included in he index.
Lawrence Carrel is an award-winning journalist and author of ETFs for the Long Run: What They Are, How They Work and Simple Strategies for Successful Long-Term Investing and Dividend Stocks for Dummies. His work has appeared in The Wall Street Journal, SmartMoney, TheStreet.com, Kiplinger’s Personal Finance Magazine, Reuters, The Associated Press, Investor’s Business Daily, Business Without Borders.com, The Economist Intelligence Unit, Financial Planning, Barron’s Online and others.