Are A-shares ready for inclusion in EM indices?

In the second of two articles looking ahead to MSCI's June decision on A-shares, some foreign investors are not sure that Chinese stocks are ready for inclusion in emerging-market indices.
Are A-shares ready for inclusion in EM indices?

Index provider MSCI is set to decide next month on whether to include A-shares in its emerging-market benchmarks, but some industry players are not convinced that the time is right, citing the mainland stock-suspension mechanism, among other issues.

Three key hurdles in respect of accessibility were addressed by changes to the qualified foreign institutional investor (QFII) quota rules in February. MSCI then started a new consultation in April, reviving the discussion about including A-shares in its EM indices.

Keen to boost its domestic stock markets, Beijing continued its push for A-share inclusion with last week’s clarification of the ownership status of securities in QFII and renminbi-QFII accounts. Chinese fund managers – and state media – have also been keenly arguing the case for inclusion, as reported yesterday.

However, concerns remain among foreign investors about the mainland stock-suspension mechanism, which was raised as an issue in the recent MSCI consultation.

Voluntary trading suspension is not new, but the major problems it can cause came into sharp relief during the mainland equity market collapse last summer. Some 1,400 companies voluntarily halted trading of their own stocks on July 9, representing around half of A-share liquidity. 

Victoria Mio, Hong Kong-based chief investment officer for China at Robeco, pointed to two issues with such suspensions. “First, we may need to estimate the fair value of the stocks during the suspension, especially when the market moves a lot,” she said. “[And] when our funds have outflows, we cannot sell our shares, which puts us in a very difficult situation.”

Nicholas Yeo, head of China and Hong Kong equities at Aberdeen Asset Management, said it was important that such an event did not happen again. Voluntary trading suspension is one example of why the market is uncertain about the principles the Chinese regulator is following, he noted.

Foreign investors’ concerns are not around technical issues, as these will be gradually overcome, said Yeo. What is key is the message from the regulator about how it will police the market, he added.

The debacle over the mainland's aborted introduction of a circuit-breaker in January this year will not have boosted confidence on this front, though at least the securities regulator admitted to flaws in its approach.

However, some suggest the trading suspension issue should not be part of the consideration about A-share index inclusion.

It is a concern, but should not be a reason to deny index inclusion, said Mark Mobius, executive chairman of Franklin Templeton's emerging markets group. “This has more to do with governance and the culture of respecting market forces,” he wrote in an email to AsianInvestor. “It is the same risk we face in many other emerging markets.”

Meanwhile, Mobius dismissed MSCI’s concern over what the index provider sees as “anti-competitive clauses”. These restrict financial institutions from launching products linked to indices containing A-shares. Such products, even if listed internationally, currently need pre-approval from local Chinese stock exchanges, a rule not seen in other emerging markets.

But Mobius said: “If such index-tracking funds are not approved, the use of the index and interest in the index will decline. My view is that this should not be a consideration and MSCI should establish an index on its own merits and not on whether it will be widely used or popular.”

Meanwhile, in an April 25 research note, Goldman Sachs pointed to other reasons why A-share inclusion may be premature: the Shenzhen Connect stock-trading link has not yet launched; the limited anount of sell-side research coverage; a lack of hedging tools (both for equities and foreign exchange); high volatility; and high valuations.

Moreover, despite the February move to allow daily capital repatriation under the QFII scheme, only 20% of a QFII fund’s net asset value can be repatriated monthly.

Still, even if MSCI does not announce A-shares’ inclusion next month, the decision will not have to wait until next year’s review, given that the index provider is allowing a flexible timetable in respect of mainland stocks.

A total of $1.5 trillion in assets ($0.2 trillion in passive funds and $1.3 trillion in active products) track MSCI EM indices. The plan is to include A-shares with a 1.1% weighting, which would bring $16 billion of inflows into mainland equities, according to Goldman Sachs.

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