The trouble with China
Investors, even at the best of times, have a habit of chasing after bright shiny objects and latching on like a fish to a lure. But in a sideways market, where everyone is chasing after any little nibble of growth, this natural susceptibility to hype is amplified.
This habit most often appears when it comes to initial public offerings (IPOs), where openingday enthusiasm soon gives way to the sober light of losses, and it’s usually retail investors who end up paying because they get in the game too late.
This week, the same kind of thing looked like it might happen half a world away, as expectation grew that MSCI Inc. — the world’s largest indexer — might finally include China A-shares in its Emerging Markets Index.
The speculation turned out to be something of a non-story, because MSCI ultimately decided to hold off for now. But it left the door open to include A-shares — stocks in mainland China companies, traded on mainland exchanges such as Shanghai and Shenzhen — in the influential index, which is tracked by more than a trillion dollars’ worth of funds all over the world.
The impact on China and other international markets could be huge. By some estimates, foreign inflows into Chinese markets as a result of full inclusion could total US$330 billion.
If, or rather when, it happens, this theoretical liquidity pump could further inflate the superhot mainland exchanges. The Shanghai and Shenzhen indexes’ one-year returns are 156 per cent and 189 per cent, respectively.
It could also displace billions of dollars from other emerging markets such as India and Korea. It’s no surprise, then, that Shanghai was up and India was down as speculation over the potential inclusion ramped up earlier this week. Should you care? Well, no. And, yes. With the affected Chinese indexes on a tear, who wouldn’t want to get a piece of that action? Full inclusion would also provide at least a temporary boost to waning emerging-market funds that track the MSCI. Lord knows they could use some help.
Yet the devil is in the details. And the details of the potential index rebalancing and the state of international access to A-shares would confuse a Byzantine courtier.
Under strict foreign investment rules, A-shares are mostly available for trading only by citizens of China, although a relatively small quota is allowed for foreign purchase through the country’s Qualified Foreign Institutional Investor (QFII) system.
A-shares can also be accessed through the Shanghai — Hong Kong Stock Connect program announced by China last year. It lets Hong Kong and qualified Chinese investors buy stocks on those two exchanges, but there are daily quotas.
There are a bunch of other complications, too. A-shares trade in renminbi, and the Chinese currency is still not fully convertible. As well, MSCI cited remaining issues over quotas for institutional investors and restrictions on beneficial ownership as reasons for its decision to stall.
It’s clear, too, that any inclusion in the index would be gradual, and the impact on prices and other markets would likely be incremental as well. Finally, even with inclusion, investors wouldn’t gain any more ability to hold A-shares directly.
Beyond all the barriers to ownership and capital flows, Chinese markets are plagued by a reputation for a lack of transparency. Chinese stock markets also have a reputation for — how to put this delicately? — a high level of enthusiasm for risk.
There is certainly nothing in China’s recent lacklustre economic performance to justify the mainland rally, which is being driven by low interest rates, government stimulus and tight liquidity.
Inclusion in the MSCI index could pump up the China stock bubble even further, and so some long-term, emerging-market investors should maybe breathe a sigh of relief.
All that said, even the fact that MSCI is seriously considering Ashares inclusion — it is setting up a working group tasked with Chinese regulators to sort out the issues — speaks to how far Chinese exchanges have come in liberalizing and rationalizing, despite continuing controls.
For instance, regulators recently began allowing short selling of shares on the Connect Exchange, and are said to be contemplating the removal of a ban on rollover margins.
Trying to get into MSCI’s Emerging Markets Index could provide momentum for further reform, and there is good reason for China to want to make changes.
Chinese companies are saddled with huge debt loads, and the government has been trying to discourage credit expansion. More foreign equity investment would be good for corporate balance sheets. Of course, that might not be good for investors.
Index inclusion or no, cracks are developing in the Chinese wall that keeps foreign investors out. But in the long term, whether or not to take advantage comes down to the health of China’s companies.
If further liberalization of China’s markets means greater corporate transparency, as surely it should, investors will want to take a close look under the hood.
Chinese companies are saddled with huge debt loads