The Daily Update - China still not an emerging market?

It seems China will have to wait another year and push further reforms in order to satisfy the requirements of MSCI that would allow its A-Shares to be classified as Emerging Market. Such a reclassification has been impending for years and yesterday MSCI again postponed the inevitable – awaiting increased capital market accessibility and transparency. It had seemed more likely now than in previous years considering the accelerated reforms of the past 12 months (which mollified the IMF sufficiently to include the Chinese renminbi into the SDR in November 2015).

MSCI previously specified three outstanding central criteria for China to meet before inclusion. More streamlined and predictable quota allocations expectations seem to have been met, as have clarifications regarding beneficial ownership laws which were a major concern. However, concerns still lingered around the Chinese authorities’ propensity to control their stock markets – epitomised in the 2015 crash and the suspensions of trading spanning large fractions of the Chinese market. Also concerns over the 20% monthly repatriation limit’s effects on mutual funds capacity to deal with large redemptions creates an obstacle to inclusion at present.

Such an eventual inclusion could see China mainland shares being gradually included across their emerging market indices and concurrently in ETFs / funds that benchmark against such indices. Already, despite this decision, the core MSCI emerging market index allocates 25% to Chinese shares (mostly those traded in the United States and Hong Kong) which for the world’s second largest economy is still proportionally underweight; China ‘s GDP is over 7x larger than South Korea’s which currently accounts for over 15% of the MSCI EM Index. Once inclusion is confirmed, a partial allocation of an additional 5% in China A-Shares is the more likely first step. Then following partial implementation the current roadmap estimates China’s proportion of the index increasing to around 44% under a full inclusion scenario – accounting for other expected changes such as South Korea transitioning into the developed market space.

Such a trend has already formed a (somewhat disregarded) discrepancy in China allocations between local currency and dollar denominated indices and ETFs with a number of hard currency emerging market ETFs holding less than 5% in China. Such a distortion could mean that some investors are unwittingly underweight China which adds further potential for flows into China in addition to its eventual designation of emerging market. With MSCI’s decision to postpone inclusion, China A-Shares dropped 1.1% but reversed this loss closing 1.6% stronger - with markets uncertain as to how much of this bounce was driven by Chinese authorities saving face. Such is the dichotomy in China, with its growing economic dominance tarnished by market improprieties. Nevertheless the trend of growth looks set to continue, and once China’s markets mature and it recognises the benefits associated with further integration, the world of indices and ETFs could find themselves playing catch-up.