China A-shares inclusion in MSCI

The MSCI Inc. annual review process outcome has just been released.

At a glance, the announcement is positive for Pakistan, Argentina and Saudi Arabia, neutral for Peru and Korea, and potentially negative for Nigeria and China.

Positive:

MSCI Pakistan: to join MSCI EM Index in the May 2017 semi-annual index review
MSCI Argentina: decision on EM reclassification in 2017
MSCI Saudi Arabia: decision on EM classification in 2017

Neutral:

MSCI Peru: to remain in MSCI EM but risk for reclassification to MSCI FM index (at least 3 index constituents)
MSCI Korea: will not be considered for reclassification to MSCI Developed Markets until 2018 (slow pace and implementation of financial reforms needed for the developed market eligibility).

Negative:

MSCI Nigeria: risk to be removed from MSCI FM index and to become a stand-alone market. Consultation will start soon and decision will be made in the coming months.
MSCI China A: to remain a stand-alone market

The biggest surprise

The MSCI Inc. decision on China comes as the biggest surprise in their announcement. MSCI Inc. recognises that a number of significant improvements have been made over the last 12 months. Some critical issues have indeed been resolved like the beneficial ownership, and some are in the process of being resolved such as the accessibility issues. Some issues remain, including the 20% repatriation limit in QFII and the pre-approval requirements for product registration (“Anti-competitive clause”) by local stock exchanges. Time is also needed to assess the effectiveness of the new stock suspension rules’ implementation.

MSCI Inc.’s focus on accessibility issues solely under the QFII regime has to be questioned and was indeed discussed in my phone call with MSCI early this morning, and in other discussions today with people that have specific insights in these issues. Significant financial reforms like RQFII, and Connect programs as well as the potential imminent launch of the Shenzhen Hong Kong Connect were not mentioned by MSCI Inc. in their communication. The sole focus on the 20% repatriation limit may indirectly reflect the legacy concerns of some asset managers on their QFII exposure and their ability to deleverage their exposure on that front. Stock Connect is still not used by most US investors as the integrated custodian-broker set-up is not market practice, and the very large RQFII quota granted to the US (USD 38bn) was announced very recently. This could mean that most US-based clients of MSCI Inc. have only QFII in mind when thinking of access to Chinese onshore markets.

Besides, the issue of pre-approval of production registration is an administrative one, which should not have required another 12 months’ delay for inclusion, and was only recently brought up. Here again, our discussions led us to conclude that some large overseas investors have been affected by this and succeeded bringing this as a convincing case in the investors’ consultation that preceded the annual review. Lastly, we would have expected a positive decision to put pressure on the regulator and the stock exchanges to strictly implement the newly issued suspension rules.

Considering the different elements flagged by MSCI Inc. as the base for their decision, we would not expect an off-cycle decision, even if it is being mentioned in their communication.

To some extent, the delay of MSCI inclusion reflects its lack of confidence on the policy transparency and implementation efficiency in China. Such concerns should gradually ease along with China’s continuous liberalisation of its capital account and further financial reform implementation.

Financial reforms remain to be a focus for the Chinese government. We remain confident that the Shenzhen Hong Kong Connect scheme will be announced in the coming weeks.

Market reaction and portfolio positioning

Onshore, there should not be a strong negative reaction from domestic markets. Although QFII/RQFII/Connect quotas have been increased over the past few years, China’s equity market remains mainly driven by domestic investors. The negative decision should also have a limited impact on the central parity rate of the RMB due to very little impact on cross-border flows. The CNY bond market should also remain resilient to the MSCI decision.

Some overseas investors may have already positioned themselves for the MSCI inclusion event in previous weeks via the Stock Connect, offshore A-share ETFs and A-share index futures but these amounts remain marginal in comparison with the daily turnover onshore. The unwinding of these event-strategy related trades will have very limited impact on the underlying domestic markets.

Offshore, investors will most likely shift their attention to a number of key decisions to be announced in the days to come: the BOJ meeting, FOMC meeting and UK referendum on EU exit.

Beyond the potential negative impact on momentum from MSCI Inc.’s decision, domestic markets will continue to react to local growth conditions and policy catalysts. We continue to favour non-SOEs companies active in the new economy sectors. Exposure to structural trends like the environmental protection industries, traceable growth, cash generating capabilities, quality of corporate governance and reasonable valuations remain key stock selection criteria.

Independently of the MSCI Inc. decision, the gravitational importance of China A-shares will not dissipate. The decision will be made sooner or later. MSCI Inc. just gave another 12 months to its clients to speed up the development of their research capabilities and infrastructure operations (trading, custodians, lawyers etc.) to adequately handle the world’s second largest equity market. Meanwhile, financial reforms will continue as this is of primary importance to China, on its course of renminbi internationalisation and supply-side structural reforms.

François Perrin – Portfolio Manager – East Capital Group