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.