MSCI Attention Relevant, But Reforms Key Drivers

After three failed attempts, the inclusion of 222 Chinese large-cap A-shares in MSCI’s Emerging Markets Index is what many market analysts say is an “endorsement” of Beijing’s efforts to deepen its capital markets.

In particular, China’s Stock Connect programs, which to-date are not subject to approval requirements, lock-up periods or repatriation limits, have made Chinese equities much more accessible than the longer-established QFII and RQFII schemes.

However, joining the index will not be a game-changer by itself. The selected A-shares will have a very small weighing of just 0.73 percent within the index, meaning any immediate practical effects will be minimal–as evident by the near non-existent moves in the market the day of the MSCI announcement.

MSCI has stated it expects the initial inflows into Chinese shares will be $17-18 billion. That is equivalent to a month’s outflows in 2016. And the effective inclusion date is not until mid-2018. “An inference of the small MSCI weighting is that China will have to quicken the pace of capital market reform if it is to make up more of the index,” Michelle Lam, London-based senior economist with TS Lombard wrote in a note to clients in June. “This could take the form of an increase in the inclusion factor (currently 5 percent) as well as the addition of China A Mid Cap shares.”

An investor looks at an electronic screen showing stock information at a brokerage house in Nanjing, Jiangsu Province, China

MSCI has estimated that, ultimately, complete inclusion of China’s A-shares in the index could yield inflows of $340 billion. It is also important to note that South Korea, for example, took six years to reach that point and Taiwan took nine years.

“If we optimistically assume that China could achieve full inclusion within five years, inflows could reach $70 billion a year – a sum that would still be less than half of last year’s total net capital outflows,” Lam explains.

And getting there will not be easy for China. MSCI has laid out somewhat very explicit criteria that China must meet to eventually qualify for a meaningful increase in its index weighting. Specifically, obtaining a greater alignment of the China A-share market with international market accessibility standards; resilience of the Stock Connect schemes and the relaxation of daily trading limits.

Photo Credit: Reuters, May 9, 2016