FTSE index changes likely to affect China, Hong Kong, Korea flows

At the close of trading on September 18, global index provider FTSE will be implementing country classification changes that were decided at its annual review this time last year. For Asia, the most significant changes involve China, Hong Kong and Korea.

South Korea will be leaving the ranks of emerging markets to join the developed markets category. So-called red-chips will be moving from Hong Kong (which is a developed market) to China (which is a secondary emerging market). Taiwan is currently in the watchlist in the emerging markets category as it works to comply with developed market requirements. China A-shares is also on the watch list for possible inclusion for secondary emerging status.

Red-chips are shares of Hong Kong-registered companies that have large interests in China. Under standard FTSE practice, a nationality rule would have kept red-chips in the FTSE China index, but a relaxation of the definition of red-chips allowed them to jump to the Hong Kong index. Now, under the new definition, a company is considered a red-chip by FTSE standards if it is incorporated outside of China and is listed on the Hong Kong stock exchange; and has a substantial ownership by mainland entities and a majority of its sales revenue or operating assets derived in the mainland.

Paul Hoff, managing director for Asia Pacific at FTSE, estimates the market capitalisation of the FTSE China Index will grow by 41% to around $504.3 billion after it is joined by red-chips from the current level of around $358.9 billion. As of now, the FTSE China index is made up of only H-shares (China-registered companies listed on the Hong Kong stock exchange) and B-shares (US-dollar denominated shares available to both local mainland and overseas investors).

Hoff expects the market capitalisation of the FTSE Hong Kong index to drop by 32% to around $347.5 billion after the removal of red-chips from the current level of around $514.5 billion.

With South Korea leaving the FTSE All-World Emerging Asia-Pacific index, China will have the largest weighting of around 30% after the changes are implemented from the current level of around 22%.

"China will be larger than Hong Kong in the global benchmark," Hoff told participants of a FTSE country classification seminar yesterday. "This takes into account that China is a bigger market than Hong Kong."

Since the announcement last year that it was going to be elevated to developed market status, South Korea has already benefited from an increase in fund inflows in anticipation of the change in benchmark weightings. Some of the new funds are expected to come later, particularly from passive investors who strictly track benchmarks. FTSE estimates that some $3 trillion in funds are benchmarked against its indices worldwide, mostly in developed markets.

The inclusion of Korea in the FTSE All-World Developed Asia-Pacific ex-Japan index will give it a weighting of around 25% in the index mainly at the expense of Hong Kong, which will see its weighting decline by around 14% to 20%, and Australia, which will see its weighting decline by around 9% to 46%.

Rival global index provider MSCI has not yet elevated Korea into a developed market status. MSCI has decided to keep Korea's emerging markets status. The MSCI Korea Index will remain under review for a potential reclassification to developed markets as part of a 2010 annual market classification review. Korea already meets the economic development, size and liquidity requirements for developed market status. However, MSCI notes that investors have continued to highlight some significant accessibility issues for Korea which are not characteristic of developed markets.

The last hurdles Korea overcame to be granted developed status by FTSE involved three requirements: a free and well-developed foreign exchange market; free delivery settlement; and off-exchange transactions. A number of regulatory obstacles were removed in Korea since 2007, meeting requirements of developed market investors, particularly in the so-called quality-of-market areas of settlement -- free delivery and short sales.

In Taiwan, some of these quality-of-market criteria are still to be met. In some cases, new regulations have been amended and submitted but are pending approval and implementation. FTSE's process requires not only additional improvements but adoption by the markets in the areas of foreign exchange, stock lending, short sales, off-exchange transactions, and T+2 settlements.

Korea and Taiwan were placed on the watch list for possible upgrade to developed market status in 2005.