Wake-up call for RMBelievers

MSCI’s no to A-shares is a time to reflect on other hurdles to China's financial liberalisation.
Wake-up call for RMBelievers

MSCI’s decision not to admit China A-shares to its global emerging-market indices suggests China is nowhere nearer an answer for what to do with the renminbi than it was a year-and-a-half ago, when  newly installed premier Li Keqiang made plain his ambitions regarding economic reform and revitalisation.

Chinese officials have not explicitly made joining MSCI indices a goal, but financial executives in Hong Kong interpreted it that way from their private talks with mandarins.

In January 2013, the then head of the China Securities Regulatory Commission (CSRC), Guo Shuqing, visited Hong Kong to announce plans for a dramatic expansion of cross-border flows. In addition to expanding the existing channels for institutional investors (QFII for foreigners, QDII for domestic investors and RQFII for foreigners investing with renminbi), he proposed introducing channels for retail flows.

Bankers told AsianInvestor this was probably aimed at an unstated goal of the CSRC: to get A-shares into MSCI’s emerging market index. One of the biggest technical barriers was a lack of daily liquidity, which retail flows would solve.

MSCI may well change its mind next year when it conducts is annual review of market structure and eligibility. In April, premier Li proposed a link between the Hong Kong and Shanghai stock exchanges to allow institutions and wealthy individuals to trade on both bourses.

Stock Connect, as the initiative is called, links the two exchanges’ affiliated clearing houses and allows people to invest across the border without a licence. It was given a six-month target to go live, suggesting trading will start by November – although Hong Kong regulators have stressed that trading only begins once rules on conduct, investigations, training and enforcement have been fully agreed.

Mutual recognition for funds is expected to follow at some point afterwards, said current CSRC chairman Xiao Gang, who succeeded Guo in March 2013.

The reason for MSCI to consider adding China is its size. The Shanghai Stock Exchange boasts a free-float market capitalisation of $2.17 trillion. Foreign quotas via QFII and RQFII schemes have grown considerably, to around $216 billion or about 10% of the free float.

But they remain plagued by restrictions on liquidity, repatriation, tax, currency hedging and choice of brokers (which impacts best execution, particularly with regard to investing efficiently in domestic exchange-traded funds). These issues prevented MSCI from admitting A-shares this time around.

For MSCI to include China based simply on market-cap weightings would put it at around 10% of MSCI’s Global Emerging Index series. Given there is some $1.5 trillion of assets tracking those indices, that would imply $150 billion worth of demand for A-shares. No one expects such an outcome; it is assumed the MSCI would coordinate with Chinese authorities to engineer a phased approach. Nonetheless the flows will be considerable if China is admitted.

A lot is therefore riding on Stock Connect and mutual recognition to drive meaningful, licence-free, daily flows over the border. Unlike previous ‘through train’ schemes, this one has the backing of the State Council, and a public deadline. But it is also one piece of a broader reform effort that appears to have stalled.

Recent policy of prodding more bank credit, tiptoeing around credit issues among ill-considered trust products, an obvious problem in real estate markets, no real results from the Shanghai financial free-trade zone and other issues suggest the economic slowdown is forcing Beijing to backtrack on restructuring.

The easiest sell politically remains internationalising the renminbi, a programme that appeals to nationalist sentiment and doesn’t on the face of things threaten entrenched interests. But increasing evidence of fragility in China’s financial system must be prompting second thoughts.

Some backers of opening China’s capital account believe this is the way to get market forces to impose discipline on domestic institutions. It might be better for all concerned that the leadership finds the political means to restructure state-owned enterprises, curb overly powerful ministries and instil a culture of commercial credit analysis in its banks before it widens the opening to capital flows.

For fund managers, getting China right is key to their business strategy for Asia. Many are now establishing, or considering, Hong Kong domiciled funds; Barings is a recent example. This makes sense for those firms able to be patient and accept the vicissitudes of doing business in an unpredictable environment.

But the MSCI decision is a reminder that in many ways China is not ready – politically most of all – to meet the demands of global investors. Indeed, the same can be said of Korea and Taiwan, which MSCI has once again declined to advanced to developed-market status.

Since the collapse of Lehman Brothers in 2008, the notion that Asian governments and financial systems would inexorably conform to international norms has been challenged. If anything, the evidence is growing that Asian societies are chafing against some of these norms (often to the detriment of their own markets and investors, but that’s another story).

For the hordes of RMBelievers out there, the bet is narrowing on Stock Connect and the extent to which it engenders not just flows, but change in China. For executives with a limited time frame, that’s a risky bet.

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