Last week saw what may well turn out to be the most important non-event of the year. If that sounds like a contradiction in terms, it is. The announcement by index compiler MSCI that from next year it will begin to include China’s onshore stock markets in its benchmark equity indices is of great symbolic significance. But for years to come, the practical impact of the move will be negligible. Certainly it will fail to trigger the massive fund inflows and resulting stock market boom that some bullish analysts are forecasting.
Inclusion in MSCI’s emerging markets index is a big deal for Beijing, because it puts an international seal of approval on China’s onshore A-share markets. With investment portfolios worth around US$1.7 trillion benchmarked against the index, it has long rankled Chinese officials that their US$7.7 trillion domestic stock market has been omitted, especially when the shares of mainland companies listed in Hong Kong have been included for more than 20 years.
But for years MSCI and the big institutional investors who use its indices have rejected Chinese requests for inclusion. If A-shares were in MSCI’s indices, then institutions benchmarked against them would be obliged to buy mainland-listed stocks. But until now, problems with the mainland’s financial regulations have always put them off.
International investors’ complaints have included three main bones of contention: the high proportion of stock suspensions in the A-share market; mainland limits on the funds qualified foreign institutional investors can repatriate; and China’s requirement that mainland regulators must approve any structured investment products that include exposure to A-shares. The first could prevent investors selling in a market rout. The second restricts their ability to get their money out of China. And the third would give Chinese regulators theoretical jurisdiction over products such as exchange-traded funds based on MSCI’s indices – a requirement completely unacceptable both to MSCI and to big fund managers.
Over the last year, the Chinese authorities have gone a long way to allay these concerns. They have introduced regulations that limit the ability of companies to suspend their stocks indefinitely in order to prevent price declines. They have scrapped the quotas that imposed aggregate limits on the flow of funds into and out of China through the “Connect” schemes linking Hong Kong with the Shanghai and Shenzhen stock exchanges. And they have promised MSCI that in practice mainland regulators will not insist on pre-approving investment products based on its indices.
In response, MSCI last week said it will include A-shares in its emerging markets and all-country indices for the first time from next year. The index compiler’s decision was hailed by mainland officials as a long-overdue acknowledgement that China’s onshore stock exchanges are no longer the arbitrarily regulated casinos they once were, and that they have finally been granted the international recognition they deserve as large and mature markets.
However, the reality of inclusion will fall far short of the expectations. If China’s US$7.7 trillion A-share markets were to be included at their full weight, they would completely dominate MSCI’s emerging markets index, which currently has a market capitalization of US$4.65 trillion. However, MSCI weights constituent markets by the size of their free-float, which immediately cuts China’s market cap to US$2.7 trillion.
Moreover, China imposes a foreign ownership cap on A-shares of 30 per cent of their free-float, which further reduces the market capitalization eligible for inclusion to US$810 billion.
Finally, in recognition of the closed nature of China’s capital account, MSCI is imposing an initial 5 per cent “inclusion factor” on the 222 A-shares it is proposing to admit to its indices. As a result, A-shares will make up just 0.73 per cent of its emerging markets index.
Given that the Hong Kong and US-listed stocks of Chinese companies already constitute 27 per cent of the MSCI emerging markets index by weight, the impact of adding A-shares will be negligible. For emerging market funds, 0.73 per cent is well within their typical tracking error, which can commonly be as high as 5 percentage points. In other words, the weighting of A-shares in the index is so low that most investors will not find it worth their while to bother buying them.
Even if international investors were to buy A-shares in line with the index weighting, the inflows into the mainland market next year would amount to a nugatory US$15 billion. Compared to turnover last year on the mainland’s exchanges of more than US$15 trillion, that is a very small drop in a very big ocean.
Of course, MSCI could raise China’s inclusion factor over time. But don’t hold your breath. After Taiwan was included in the MSCI emerging markets index in 1996 at an inclusion factor of 50 per cent – 10 times China’s level – it took 10 years for its inclusion factor to reach 100 per cent. And even if the A-share inclusion factor were to be raised to 100 per cent by 2027, the annual inflows into the mainland’s markets would only reach US$40 billion.
In other words, there is no way inclusion in MSCI’s indices is ever going to drive the great A-share bull market that some observers seem to be hoping for. ■
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 20 years