MSCI Forgets Its Doubts About China
In the culmination of a long-running saga, MSCI Inc. yesterday announced that it would include some Chinese stocks in its widely used benchmark indexes, starting next year. China has taken this as recognition of its growing economic and financial might. But the decision seemed to have almost nothing to do with the reality of China's financial markets.
For one thing, MSCI seems to be ignoring much of what it said in the past. In yesterday's announcement, it suggested that the recent expansion of a stock-connect program was one development that counted in China's favor. But the big stocks that will be included in the index primarily trade on the Shanghai-Hong Kong Stock Connect, which was launched in 2014. It was up and running when MSCI rejected China for inclusion in the indexes in 2015 and 2016. So it seems like an odd basis for inclusion now.
Likewise, MSCI last year cited the tendency of Chinese companies to halt trading whenever market conditions worsened or bad news came out as a basis for rejection. Yet this year, it evidently had no qualms about roughly 10 percent of A-share companies having voluntarily suspended themselves. Worse, it said that "a two-step inclusion process will be used to account for the existing daily trading limits." In other words, it's creating a special workaround to avoid running afoul of market limits imposed by China's regulators.
Another obstacle cited last year was the ability to sell stock and repatriate funds to investors, which is especially critical for index investors. Given that this year, MSCI gave almost no mention of capital-mobility issues, even as China's crackdown on capital outflows has many companies and investors fretting, it looks like the company was willing to bend its own rules.
Recent history suggests an important lesson here. In September, the International Monetary Fund announced that it would include the yuan in its basket of major international currencies, called the Special Drawing Rights basket. To be included in the SDR basket, a currency is supposed to be widely used, international and freely convertible. At the time, global yuan payments (excluding transactions within China and Hong Kong) were only slightly more than the South African rand and less than the Polish zloty. Further, the offshore yuan was sinking rapidly as China clamped down on capital outflows, the exact opposite of how a free and international currency should behave.
Today, the yuan is sandwiched between the Mexican peso and Danish krone in terms of international transaction volume. Yuan deposits in Hong Kong, the primary offshore center, are down 47 percent from their peak as China's citizens face substantially tightened restrictions. China joined the SDR basket and promptly made its currency significantly less international. Even now, prominent academics wonder whether the yuan should be ejected from the basket altogether.
To its credit, MSCI seems more or less aware of these risks. It even seemed to be distancing itself from its own decision. It opened the announcement by proclaiming "broad support from international institutional investors with whom MSCI consulted." (If there's one thing you can count on, it's investors overlooking risk in search of the next growing market.)
MSCI even acknowledged that effectively every problem it cited last year still exists today. Increases in China's weighting, it said, will require better market accessibility standards, along with "relaxation of daily trading limits, continued progress on trading suspensions, and loosening of … index-linked investment vehicles." These were the very reasons cited for China's rejection last year, and sound more like fond hopes than anything that might happen soon. Nevertheless, MSCI is "hopeful that momentum of positive change" will "continue to accelerate."
China is undeniably an increasingly important market, and higher flows of investment capital will be to its great benefit -- and eventually to the world's. But lowering the standards of what constitutes a market and obfuscating real problems just exposes unknowing foreign investors to elevated risks. If Chinese investors and even regulators are so wary of Chinese stocks, why encourage foreigners to enter the fray?
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