MSCI Inc.’s decision on June 14, 2016 to not include China A-shares in the MSCI Emerging Market Index (EMI) is seen by some analysts as a blow to the country’s efforts in raising its stock market profile and turning the RMB into an international currency. This exclusion has happened before — for the third year running, China’s A-shares have not been in the Index (Hughes & Bullock, 2016).
The outcome of MSCI’s decision is not unexpected. On May 10, Bloomberg surveyed 23 stock market strategists. 10 predicted inclusion, 5 forecasted rejection and 8 said it was too close to call (“MSCI rebuffs Chinese,” 2016).
According to the statement from MSCI, its decision to delay the inclusion of China A-shares this June does not “rule out a potential off-cycle announcement” ahead of the next regular June 2017 review. The statement recognizes that China has introduced significant improvements that touched on major issues previously cited as impediments to inclusion. These issues are: resolution of the problems regarding beneficial ownership, enhanced regulations on trading suspension, and QFII policy changes aimed at addressing quota allocation and capital mobility restrictions. The statement also acknowledges the ongoing reform efforts of Chinese regulators.
Chinese securities regulators have worked closely with MSCI to facilitate the inclusion of China A-shares in the MSCI EMI. The resolved issues, as mentioned before, are the following (“Results of MSCI,” 2016).
(1)Resolution of the issues regarding beneficial ownership: In early May, China Securities Regulatory Commission (CSRC) clarified the beneficial ownership issue, and most international institutional investors were satisfied with the clarification.
(2)Enhanced regulations on trading suspensions: In May, the Shanghai and Shenzhen stock exchanges published rules restricting voluntary trading halts of listed Chinese companies. The time for restructuring-related voluntary suspensions is now limited to three months and other types of suspensions to one month. This is a significant improvement from previous suspension practices, which sometimes ran into years with extensions. The suspension of stock trading was a focal point in this year’s discussion. It was noted that in the stock market turmoil last year, more than a half of all listed companies, or over 1400 firms, suspended their share trading and virtually froze the market. Many analysts thought the trading suspension worsened the volatility at that time.
(3)QFII policy changes aimed at addressing quota allocation and capital mobility restriction: In February, regulators revised the quota rule, essentially liberalizing quota allocation rules for QFII institutions with Assets Under Management (AUM) up to USD 5 billion. New rules also allowed qualified traders to move funds in and out of the country on a daily basis, shortening repatriation restrictions on qualified investors from one year to three months and easing capital-lockup. In June, China gave a RMB 250 billion investment quota to the US, allowing American institutions to convert offshore RMB to onshore RMB for investment in the mainland stock market.
Obstacles to Inclusion
The MSCI statement said that the outstanding hurdles for the inclusion of China A-shares in the EMI are the “20% monthly repatriation limit” and “local exchanges’ pre-approval restrictions on launching financial products” (He, 2016).
The first hurdle capped the QFII funds repatriation to 20 percent of the previous year’s Net Asset Value (NAV). This measure is designed to prevent a massive capital outflow in case of a market meltdown. While the rule is uncommon nowadays, its role as a macro-prudential policy tool for countries with volatile foreign exchange inflows and outflows is generally accepted. With the present stability of RMB exchange rate and foreign exchange reserve position, working out a solution to this hurdle is not a big problem in the future.
The second hurdle refers to the broad pre-approval restrictions imposed by Chinese stock exchanges on launching financial products linked to indexes that include China A-shares. These restrictions apply to both new and existing financial products. MSCI pointed out that the breadth of the restrictions is unique to emerging markets, and that there is a possibility that existing financial products in the MSCI EMI would be in danger of facing trading disruption if China A-shares were included and if a Chinese exchange withholds its approval of MSCI’s licencing of the MSCI EMI as the basis of that product. While MSCI wants the Chinese authority to ease this hurdle, Chinese market reality shows the merit of keeping such a restriction in place.
A look at the trading records right before MSCI’s decision reveal a significant build-up in China’s A-share activities in 3 areas. These areas (refer to Figures 1-3) are: A-share index futures (USD 4.1 billion open interest by contract value), Stock Connect (USD 2.7 billion northbound trade), and offshore A-share ETFs (USD 0.8 billion net subscription). While the activities in Figures 2 and 3 reflected genuine demand for A shares, the activity in Figure 1 can be interpreted as an attempt to play the market through index leveraging. The run up in nominal value of the stock index future open interest is higher than the combined increasing flow through the Shanghai-HK stock connect and HK listed A-share ETF.
Market Expectations before the MSCI Inclusion of a Share
China had indicated its desire to use the stock market as a conduit to channel citizens’ savings to productive investment. However, market reality still reflects a propensity to play the market through leverage.
On the two hurdles mentioned by MSCI, the second point is particularly vexing. The power of the exchange to approve derivative financial product launches is important in limiting potentially lethal products from getting onto the market. This is relevant for China as the market often favors highly leveraged financial products and derivative products are often highly leveraged, and the situation can easily get out of hand if the derivative is traded elsewhere in exchanges outside China. Regulators would lose the ability to dampen speculation through the calibration of margin requirements.
While earlier experiences elsewhere around the world have shown the stabilizing effects of index trading and circuit breakers at times of market volatility, a combination of factors ranging from poor mechanism design to immature retail participant behavior during crises made those instruments toxic in China.
Impact of Non-Inclusion
There is an estimated USD 1.5 trillion in passive stock market funds tracking the MSCI EMI, and the much talked about 5 percent initial weighing of China A shares in the index means an ultimate inflow of around USD 75 billion over an extended period of time, probably in a year or two. Weighing that amount against the daily trading volume of USD 60-100 billion of the Chinese A share market means that non-inclusion is not a significant market event. This can be seen by the initial market reaction following the MSCI announcement, whereby the Deutsche X-trackers Harvest CSI China A-share ETF dropped 2.3 percent after hours but the Shanghai market rose 1.6 percent when trading resumed the next day and recovered almost all the losses overnight. A week after the decision was announced, the inclusion of Chinese A-shares in the MSCI EMI was scarcely mentioned.
Importance of Stock Market Reform
Employee stock ownership and regulators’ efforts to raise stock market governance standards have become critical under the accelerated SOE reform plan. Over the past few months, their work with MSCI on regulatory changes has shown Chinese regulators to be determined in putting in place a functional market. Now with the low hanging fruit picked up, the more intricate issue keenly watched by the market will be whether the Chinese market will follow the wishes of international investors — to allow an active derivatives trading role in the stock market — or whether Chinese stock market regulators will scale back their ambition and limit the role of the stock market to its traditional role of corporate fund raising. The issues of complementary policy and timing will test the capability and political will of the regulators.
Aside from the two operational obstacles that MSCI mentioned in its press release, MSCI’s rejection of China A-shares in its EMI also reflects its belief that China’s domestic stock market regulatory environment and corporate governance still fall short of the standards required to enter mainstream global investment. Assuring a long term healthy environment for both the capital market and macroeconomic environment is as indispensable as addressing market players’ quest for liquidity and operational efficiency in attracting international participation. This is currently lacking in the Chinese stock market.
Many observers have noted the unsettling fact that Western institutions continue to mistrust China’s systems. There is a tendency to apply a higher standard and follow a stricter interpretation of what is happening in China as compared to other emerging economies, and the two remaining hurdles will probably not be an issue in other emerging markets.
The bungled stock market rescue and poorly handled RMB trading band widening in 2015 have taught invaluable lessons to Chinese regulators. The successful restoration of market order in both markets highlight the importance of understanding the peculiarity of Chinese markets and the coordination issues among different financial regulatory policies. With a market capitalization of USD 7 trillion, second largest in the world after the US (Gao, Lu, Lv, & Weng, 2016), it is a matter of time that MSCI must include China A-shares in its EMI if Chinese can prove its long term investment value to both domestic and international investors. MSCI does not really possess the king maker’s role for international acceptance of Chinese A-share market as a sound investment destination.
Blessing in Disguise?
On hindsight, the non-inclusion of China A-shares in the MSCI EMI is probably a blessing in disguise as it gives regulators more time to design a more stable and prudent market structure prior to a wider market opening. At the same time, it gives a clear signal to China that it must implement further reforms and strengthen the system.
Chinese economic decision makers seen to be quite uncertain as to whether the economy should take a faster pace of growth through demand management or concentrate more on deleveraging and tackling reform issues, as manifested in the recent open debate among leaders on “supply-side” policy. The decision on the pace of stock market opening is part of the overall “supply-side” policy debate. At this juncture, it is quite clear to the outside world that China has not made up its mind on whether it should speed up the opening of the financial sector. In particular, there are strong indications that President Xi is about to overhaul the organizational framework of financial sector regulations and high level changes will come in the 19th party congress in 2017.
In any case, China should not sacrifice its macro-prudential regulatory standard for the sake of getting into the index, nor should it satisfy the claim that getting into the index will help in RMB internationalization. President Xi’s famous statement on reform — that reforms are forced out when circumstances are dire (改革是倒逼出来的) — aptly describes the dilemma currently faced by Chinese capital market regulators. How they strike a proper balance between a healthy capital market and liberalization will be closely watched by all observers.
Gao, T., Lu, W., Lv, M., & Weng, J. (2016). MSCI delays China A-shares inclusion again. Report. UBS.
He, L. (2016, June 15). Why China failed in its third try to join the MSCI club. South China Morning Post. Retrieved from http://www.scmp.com/business/companies/article/1975490/why-china-failed-its-third-try-join-msci-club
Hughes, J., & Bullock, N. (2016, June 16). MSCI delays including China A-shares in its indices. Financial Times. Retrieved from http://www.ft.com/intl/cms/s/0/a3681d18-3218-11e6-ad39-3fee5ffe5b5b.html
MSCI rebuffs Chinese shares for third time in blow to Xi's goals. (2016, June 15). Bloomberg. Retrieved from http://www.bloomberg.com/news/articles/2016-06-14/china-stocks-denied-msci-entry-in-blow-to-xi-s-global-ambitions
Results of MSCI markets classification review: MSCI to delay including China A shares in the MSCI Emerging Market Index. (2016, June 14). MSCI. Retrieved from https://www.msci.com/documents/10199/4b1ba122-5f18-4a36-91c0-41a9b358c2ff