China Gets in the MSCI. Now Comes the Hard Part.

Officials need to use this as an opportunity to advance reforms in the nation's capital markets.

Chinese stocks join the world stage.

Photographer: Qilai Shen

The China Securities Regulatory Commission stated that MSCI Inc.'s decision to include the nation's stocks in its benchmark equity indexes for the first time reflected global investors' confidence in China's economy and capital markets. The naysayers were quick to point out that just 222 large-cap shares will be included, accounting for a 0.73 percent weighting in the MSCI Emerging Markets Index. That's tiny considering China is the world's second-largest stock market.

I believe that it’s strategically important for China for several reasons, and officials need to use this as an opportunity to advance reforms in the nation's capital markets.

At its core, MSCI's decision is an acknowledgement of the significant progress China has made on reforms in the past year. Accessibility of the A-share market for global investors has been the key reason for previous rejections from MSCI, and the development of the Shanghai and Shenzhen stock connects have been important developments to overcome this hurdle. MSCI noted that "Institutional investors viewed the Stock Connect as a more flexible access framework compared to the QFII and RQFII regimes." CSRC Chairman Liu Shiyu has also taken steps to create a more robust regulatory regime, which has made the equity market more suitable for international institutional investors. Plus, this is more recognition of China’s growing influence in the world economy and financial markets, similar to the yuan's inclusion in the International Monetary Fund's Special Drawing Rights program last year.

After the announcement, the Shanghai Stock Exchange said in a statement that the "Exchange will actively explore new models and mechanisms for internationalization, and plans to keep building the blue chip market and 'smoothly' develop derivatives and funds markets." MSCI noted that potential next steps include a bigger so-called inclusion factor, which would increase the weighting of Chinese shares in the index over time, if China continued to progress on their reform agenda. Fewer restrictions on capital flows and the development of index futures for international investors are two important hurdles that have been identified by global investors. Additionally, reform of the IPO mechanism is important for China as a way of improving the allocation of capital and reducing corporate reliance on bank loans. In the first quarter, only 4.25 percent of non-financial total social financing came from the stock market, at a time when corporate debt exceeds 150 percent of gross domestic product.

Another benefit is that China's stock markets should become more institutional and grow over time. At present, China’s stock markets are dominated by retail investors, with domestic and foreign institutional investors accounting for a smaller proportion of turnover compared with major developed stock markets elsewhere. MSCI stated that the initial inclusion plan will mean more than $17 billion of international inflows to the Chinese market, with the amount increase over time to an estimated $30 billion to $35 billion once MSCI boosts the universe to 450 shares from 222. More institutional capital has the potential to help reduce volatility in the market.

I expect the progress on the equity market to be extended to the domestic corporate bond market. The Hong Kong Exchange recently confirmed that the bond connect program from the mainland and Hong Kong is in the final stages of preparation. China is the world's third-largest bond market, however trading is relatively illiquid, and foreign participation is less than 2 percent of the market. Implementation of the bond connect program could lead to inclusion in the JPMorgan GBI EM index, the Bloomberg Barclays Global Aggregate index and the Citi World Government Bond Index. Like in the equity market, the introduction of foreign capital could boost liquidity and the size of the bond market. 

Finally, there will be greater scrutiny of Chinese companies as global investors now have more of an incentive to spend more time and resources on China.

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