Is it time to drop China from emerging market indices? Easier said than done

It is true that China-related risks, from the trade war to the crackdown on private-sector activities, have become more acute
However, China’s removal from the MSCI Emerging Markets Index would still leave the gauge with a bias towards Asia

Nicholas Spiro

Published: 2:30pm, 18 Nov, 2021

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Has China outgrown the main emerging market stock indices, and should it be separated from the gauges to help investors exploit opportunities and manage risks in developing economies more effectively?

These questions have become more pertinent as China’s weight in the benchmark MSCI Emerging Markets Index has doubled over the past five years, reaching as much as 43 per cent in the fourth quarter of last year.

As China’s dominance has grown, China-related risks, from the trade war to the recent regulatory crackdown on a swathe of private-sector activities, have become more acute.

The outsize weight and influence of the world’s second-largest economy in emerging market indices have given impetus to a debate in the investment community over the merits of carving China out of the indices to help build an “emerging market ex-China” asset class.

While MSCI launched an index in 2017 that tracks non-Chinese stocks in developing economies, it has proved extremely illiquid compared with investment vehicles that offer traders exposure to Chinese equities.

However, in a provocative report published on October 20, Goldman Sachs made a case for a major emerging market ex-China asset class, citing the positive effects of Japan’s separation from MSCI’s Asia index in 2001 after the country’s share had grown to more than 70 per cent. Following the carve-out, both Japan’s and the rest of Asia’s stock markets continued to attract hefty inflows.

Goldman Sachs’ argument is twofold. First, emerging market equity investors would be better served by having a more balanced and diversified exposure to developing economies. Just as the Shanghai, Shenzhen and Hong Kong markets are deep and liquid enough to form a separate asset class, the rest of the emerging market equity universe is too big and disparate not to be treated separately in investors’ portfolios.

According to the report, more emerging market ex-China financial products would allow investors to “control their China risk better”, while making it easier to capture the “different market, sector and macro” themes and trends in Europe, Latin America and other parts of Asia.

Second, the emerging market equity landscape outside China is highly investible, under-owned by global asset managers and less correlated with Chinese growth than it was a decade ago. Almost half the stocks in MSCI’s Emerging Markets Index are outside China, with Europe and Latin America accounting for one-third of the non-China index.

Moreover, from a sector standpoint, emerging market shares outside mainland China offer investors greater exposure to the technology hardware and semiconductor industries that dominate the equity markets of Taiwan and South Korea.

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This contrasts markedly with the current emerging market index, whose performance is heavily dependent on the internet and consumer retail stocks that have the largest weightings in China’s stock market.

Goldman Sachs puts more flesh on the bones of arguments that have been made more forcefully by other investors and commentators over the past few years. Yet, dropping China from emerging market stock indices raises awkward questions and is easier said than done.

For starters, it is highly unlikely that these arguments would gain as much traction as they are today if it were not for the sharp deterioration in sentiment towards China amid mounting concerns about Beijing’s crackdown on private enterprise.

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Chinese stocks are down more than 6 per cent this year, causing emerging market equities to languish just as shares in developed economies hit all-time highs. Exposure to the most China-sensitive assets has been a harrowing experience this year.

Yet, the case for splitting China off from the emerging market index would be much weaker if sentiment was more upbeat. Few emerging market investors were complaining during China’s bull run in 2016-17, which helped drive a sharp rally in the shares of developing economies.

More importantly, an emerging market ex-China asset class is no panacea. While it would be less sensitive to Chinese growth, it would be more vulnerable to increases in US interest rates because of the greater sensitivity of Latin American and Southeast Asian economies to shifts in US monetary policy.

Furthermore, China’s removal from the emerging market index would still leave the gauge with a heavy bias towards Asia. Taiwan and South Korea alone have a more than 40 per cent share in MSCI’s emerging market ex-China index.

Building a new benchmark emerging market ex-China gauge that would leave two-fifths of the index heavily exposed to China’s economy would prove challenging. Indeed, if part of the rationale for creating a new asset class is to reduce China-induced volatility, the heavy weighting of Taiwan – which is locked in an increasingly tense stand-off with Beijing – is problematic.

The reality is that, while some investors would prefer China to be dropped from emerging market indices, most remain unconvinced and are willing to take the rough with the smooth.

Nicholas Spiro is a partner at Lauressa Advisory