MSCI betting that China will change is wishful thinking

CAN you get China to change? That’s the underlying question investors should ask themselves following MSCI Inc’s decision to add mainland shares to its benchmark indexes.

At the initial stage, 222 A shares will be included with a total weight of 0.73%. Offshore-traded Chinese companies already comprise a large chunk of the MSCI Emerging Markets (EM) Index.

For Beijing, it’s a coup, but as I have noted previously, there are still risks.

Money managers creating exchange-traded funds will still require Chinese stock-exchange approval, and the broader market remains prone to trading halts.

The number of trading suspensions in the China A-share market is by far the highest in the world, according to Credit Suisse Group AG.

There are currently more than 100 names suspended, representing 5.3% of the MSCI China A international index’s weight.

Some of the hand wringing may be overdone, because many mainland shares are already accessible to global investors through trading pipes routed via Hong Kong.

But the MSCI EM Index is a different beast, tracked by more than US$1 trillion of pension money and passive funds.

At some point, more A shares may become part of it, although that hinges upon further reforms. China A shares could account for 9% of the index within five years and attract some US$230bil of inflows, according to Goldman Sachs Group Inc.

Commenting in a statement after news of the inclusion, the China Securities Regulatory Commission said it plans to facilitate foreign money managers’ A-share investments, adding the decision shows international confidence in China’s economic prospects.

As Bloomberg Intelligence economists Tom Orlik and Fielding Chen note, the “hope is that the symbolic win adds momentum to a process aimed at increasing the openness and efficiency of China’s capital markets”.

But as history shows, previous engagements between the world and Asia’s biggest economy haven’t always resulted in freer markets.

Sixteen years after China joined the World Trade Organisation, foreign carmakers and investment banks are still forced to form joint ventures with local partners.

Just months after the yuan was included in the International Monetary Fund’s elite club of global reserve currencies, Beijing imposed capital controls to prevent it from falling, undermining China’s quest to make its currency a global one.

The entry of China stocks is just one small step toward drawing the world’s second-largest equity market into the global sphere.

Exposure may be limited, but a repeat performance of 2015’s China stock-market crash could have huge ramifications.

All those pension funds that track MSCI indexes should brace for some volatility.