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MSCI verdict on Chinese shares could speed up liberalization

17-06-2016 | Insight | Victoria Mio A decision by MSCI to delay the inclusion of Chinese A-shares in a key index could speed up liberalization of the market, says fund manager Victoria Mio.

Speed read:
  • MSCI decided not to include A-shares in its Emerging Markets Index
  • Indexing group cites a few hurdles to free movement of capital
  • Move may encourage a speedier liberalization of the domestic market

MSCI said on 15 June that it would not include yuan-denominated China A-shares in its Emerging Markets Index, citing a few hurdles and risks to the free movement of capital. The group applauded the significant progress made so far by Chinese regulators, but said more needs to be done to meet MSCI’s global standards.

While the Chinese stock market authorities were disappointed by the decision, the silver lining is that it offers a golden opportunity to speed up the liberalization process on the mainland market, says Mio, portfolio manager of Robeco Chinese Equities.

“We think the delay of inclusion will actually encourage the regulators to improve the mechanisms,” she says. “The fact that many large international funds have already found ways to invest in A-shares should mean that the impact of this delay is relatively small.”

“Overall, the inclusion will depend on how China’s market liberalization progresses. China will continue to push forward with its financial market reforms. And the Chinese market is too big to be overlooked: the inclusion of Pakistan shows that inclusion does not depend on market size, but rather on the market’s condition and how open it is.”

Vast potential inflows
The huge size of the Chinese stock market means the potential future inflows for investors able to freely buy them runs into hundreds of billions of dollars. If 5% of the A-share market is included in the index, it would mean inflows of USD 21 billion overnight. If 100% inclusion happens, potential inflows are estimated at USD 364 billion, or 18% of the free float market cap of the entire globalized index.

MSCI said there were two remaining obstacles to be addressed:
  • Effective implementation of recent quota allocations and capital mobility policies; the 20% monthly repatriation limit remains a significant hurdle for investors
  • Problems relating to pre-approval requirements for launching financial products on local stock exchanges, mostly due to concerns about how they are packaged.

Stock suspensions for companies with volatile share prices have been particularly troublesome, and ‘circuit breakers’ designed to stop erratic trading dramatically failed in January, prompting a significant decline. Under QFII, foreign investors also face some restrictions to take money out of the yuan-denominated market, unlike the freely traded Hong Kong dollar H-share market. Chinese H-shares listed on the Hang Seng Index are currently included in the MSCI and other indices, accounting for 26% of the market’s weight.

Good progress so far
However, MSCI was complimentary about the progress that China had made with market modernization so far. “There have been significant steps toward the eventual inclusion of China A shares in the MSCI Emerging Markets Index,” says Remy Briand, MSCI Managing Director and Global Head of Research of the New York-based group.

“They demonstrate a clear commitment by the Chinese authorities to bring the accessibility of the China A-shares market closer to international standards. We look forward to the continuation of policy momentum in addressing the remaining accessibility issues.”

MSCI said it would retain the China A-share inclusion proposal as part of the 2017 Market Classification Review, and it did not rule out a potential off-cycle announcement should further significant positive developments occur ahead of next June.

msci-verdict-on-chinese-shares-graph1.jpg 
MSCI China A share inclusion Roadmap. Source: MSCI, Robeco.

Mio says the experience of South Korea and Taiwan in trying to get into the index bodes well for China. It took Taiwan nine years and South Korea six years before their markets were fully included, and in South Korea’s case, an increased weight of stocks included directly followed liberalization of the country’s capital market.

“We think China may be a similar case to Korea to certain extent, as China’s capital market is not liberalized.” Says Mio. “But to be fair, the Chinese market in 2016 is actually more open than the Korean market before its first inclusion in 1992. Increased foreign ownership will lead market behavior to converge with that of global markets in the long run.”

Other countries were also affected by the MSCI review. The group said that Pakistan would be promoted to emerging markets status in May 2017, and that Argentina would be considered for promotion to this category in the June 2017 review. However, South Korea would not be included in next year’s review for promotion to developed markets status, due to restrictions on converting the Korean won and other domestic tradability problems.

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