China’s Inclusion in MSCI Benchmark Equity Index Spells New Risks for Institutional and Individual Investors

Although Chi­nese stocks were bumped up to an 18-month high as a result of Bei­jing hav­ing achieved its long-cov­eted inclu­sion in MSCI’s global bench­marks (includ­ing its flag­ship Emerg­ing Mar­kets Index) for the fist time (after three failed attempts), there are abun­dant rea­sons for cau­tion among U.S. and other for­eign insti­tu­tional and indi­vid­ual investors.  Accord­ing to HSBC, as much as $500 bil­lion from for­eign investors could ulti­mately flow into China’s domes­tic exchanges in the com­ing years, should com­pa­nies like MSCI and FTSE Rus­sell give full weight to Chi­nese stocks in their indexes.

At this point in time, how­ever, only some 222 Chi­nese stocks (known as A-shares) are sched­uled for inclu­sion in the bench­marks roughly a year from now.  MSCI antic­i­pates about $17 bil­lion mov­ing into China’s domes­tic mar­kets ini­tially.  The company’s Emerg­ing Mar­kets Index alone is tracked by funds with some $1.6 tril­lion of assets under man­age­ment world­wide that will be oblig­ated to buy the Chi­nese stocks selected.

Mar­ket play­ers have been very keen to gain access to the Shang­hai and Shen­zhen exchanges with com­bined cap­i­tal­iza­tion of some $7.5 tril­lion. Despite China being the sec­ond biggest equity mar­ket in the world, for­eign investors only rep­re­sent 2% of total equity hold­ings.  That said, Chi­nese stocks traded in Hong Kong and New York already made up some 27% of MSCI’s Emerg­ing Mar­kets Index.  Reports indi­cate that it was the open­ing of a “Stock Con­nect” trad­ing link between the Shang­hai and Shezhen mar­kets and Hong Kong that served as the prin­ci­pal cat­a­lyst for this devel­op­ment.  This arrange­ment allows investors to avoid the cap­i­tal restric­tions that they would face buy­ing shares in these domes­tic Chi­nese mar­kets in ren­minbi.

There are down­side risks, how­ever, of this action by MSCI.  Chi­nese stock mar­kets are still politi­cized and sub­ject to manip­u­la­tion by the state, as wit­nessed dur­ing the mar­ket “cor­rec­tions” that occurred dur­ing the sum­mer of 2015, and again in early 2016. Nearly two-thirds of stocks MSCI will include are state-con­trolled.  It is still the case that state-backed Chi­nese invest­ment funds are ordered to buy or sell shares accord­ing to the government’s deci­sion to con­trol undue mar­ket volatil­ity.  Short sell­ing has, in the past, been sus­pended alto­gether at such times, as has the trad­ing of as much as half of the stocks in these exchanges for an extended period of time.

Beyond Chi­nese insti­tu­tional short­com­ings and high cor­po­rate debt lev­els are the risk pro­files and global foot­prints of a num­ber of Chi­nese enter­prises slated to be included in the MSCI bench­marks.  Some have poten­tial affil­i­a­tions with the Chi­nese national secu­rity estab­lish­ment and mil­i­tary.  Oth­ers may be asso­ci­ated with con­tro­ver­sial projects abroad, such as island-build­ing in the South China Sea.  Some Chi­nese com­pa­nies have engaged in ille­gal hack­ing, U.S. sanc­tions vio­la­tions, pro­lif­er­a­tion-related activ­ity and other high-risk endeav­ors.

These risk fac­tors are now more rel­e­vant to mar­ket play­ers due to the MSCI’s recent announce­ment and will require height­ened dili­gence efforts to prop­erly nav­i­gate in the period ahead.