MSCI Inc. dealt a surprising blow to China last week, by again delaying to add Chinese A-shares in the company’s benchmark index for emerging markets.
The market index provider rejected inclusion of Chinese shares into its MSCI Emerging Markets Index, due to worries surrounding transparency of the Chinese markets and capital controls of regulators.
In the end, it was the correct decision. While China has worked over the last year to improve accessibility and liquidity, MSCI’s decision is a wakeup call. Beijing needs more action, less talk if it wants to be treated like any other capital markets.
MSCI’s decision caught many international banks by surprise, as Goldman Sachs, Citigroup, and HSBC all expected China A-Shares to join the global index this month, with Goldman pegging China’s chances at 70 percent.
But it really shouldn’t have been a surprise to market participants. Last year’s snub by MSCI was announced in June—in the midst of the Chinese stock market bubble—and the Chinese Communist Party subsequently outlined a number of market liberalization measures to meet MSCI’s requirements.
Then the bubble burst and stock markets crashed. Assurances of a free market with minimal intervention were quickly discarded.
Regulators resorted to wide ranging measures aimed to stem the stock market decline last summer, including halting initial public offerings, banning short selling of shares under threat of arrest, forbidding major shareholders from selling any stock, forcing banks and institutional investors to pledge buying more shares, and running editorials in major state media encouraging investors to purchase more shares.
Individual high-level government officials also blamed various “foreign political forces” of intentionally orchestrating the stock market crash.
Naturally, global investors were spooked by China’s heavy-handed and seemingly haphazard reaction to market gyrations.
Moving Capital Freely
After the Chinese equities markets stabilized somewhat, China earlier this year promised to curb arbitrary trading halts and increase cross-border funding flow, as part of its concessions to address global investor concerns.
But according to MSCI—which solicits feedback from market participants—investors aren’t yet convinced and need more time to assess effectiveness of these policies and see them in action.
Central to MSCI’s decision are investor concerns around market access and capital controls.
China has been slowly loosening market restrictions since its currency has gained greater acceptance worldwide, and it created a Qualified Foreign Institutional Investor (QFII) scheme to allow foreign firms the ability to access Chinese capital markets.
But the QFII scheme has a quota and a lengthy application process. In a discussion around its June 2016 classification decision on China A-shares, MSCI says many international institutional investors are still awaiting QFII quota allocation monthly after submission their applications.
MSCI says that the mechanism for allowing daily capital repatriation, announced in February, still has not come online as of June.
Other concerns relate to repatriation of QFII proceeds, which China caps at 20 percent of prior year average net asset value. This monthly limit, MSCI says, is a “significant hurdle” for asset managers especially during times of market stress when they are legally obligated to meet client redemptions and withdraws.
China has made a lot of announcements about freeing up its capital markets over the last few quarters. But much of that remains just talk, and some of the newer initiatives haven’t been put in place. For MSCI, Beijing must demonstrate that a robust capital flow system is in place—and functioning as intended—before it can gain confidence of foreign institutional investors.
Future Inclusion No Guarantee
“We believe the delay of MSCI inclusion to some extent reflects [investors’] lack of confidence on the policy transparency and implementation efficiency in China,” wrote UBS Securities in a research report last week. “We think such concerns should gradually ease along with China’s continuous liberalization of its capital account.”
UBS’s opinion may be a bit sanguine. If the major gating issue for global investors is capital mobility, they shouldn’t hold their breaths on a resolution.
Due to anemic economic growth outlook, a weakening yuan, and continued expectation of an interest rate hike in the United States, China is unlikely to loosen capital controls in the near future. In fact, it’s been Beijing’s recent policy to clamp down on capital outflows.
In an article on Xinhua, China’s state-controlled news agency, columnist Zhang Zhongkai wrote that in regards to capital repatriation, “International investors should not hold out for the ‘perfect scenario.'”
“It’s rare, even though not impossible, for a country to further open its capital account when growth is slowing and funds want to leave. Zhang Yu, an analyst at Minsheng Securities Co., said in a Bloomberg interview.
Zhang said this is “An issue much larger than the stock market… We are still not a free market.”
In other words, there’s an impasse which—given the current economic and political situation in China—regulators are not likely to resolve quickly.
The Chinese equity market is huge, with total market cap of $6.9 trillion between Shanghai and Shenzhen. Those are figures that international investors simply can’t ignore. The fact that they are concerned about capital liquidity is an indictment to Chinese Communist Party regulators.
It also means that MSCI made an easy, and correct call.