Partial inclusion of Chinese shares in MSCI on the way?

IT IS that time of year again - when the annual review of index provider MSCI on June 15 decides whether to include China's A-shares into its emerging markets (EM) index.

A-shares on May 30 jumped more than 3 per cent on no obvious news, and continued to outperform a few days later.

Market chatter points to a renewed excitement of a potential inclusion, which was fanned noticeably by Goldman Sachs raising the odds of a positive outcome to 70 per cent, from a coin-toss previously.

Last week in Europe, I was also asked by journalists about the upcoming MSCI decision. But with all the turmoil in A-shares over the past 12 months, my immediate response was "given it wasn't included last year, I cannot see what has changed since that would swing the decision this time around".

But clearly there are different views in the market, and so let's dig a little deeper.

Improvements since last year

An obvious starting point of the analysis is to take a look at MSCI's assessment last year for not including China, and see what are constraining factors. We then explain the progress, if any, made since then to ease these constraints:

What changed: SAFE (State Administration of Foreign Exchange) has recently announced that the quota allocation of QFII will be linked to the investment fund size.

For the base quota (less than US$5 billion), it can be obtained automatically, and there is no particular restriction on quota top-ups.

What changed: the repatriation frequency for QFII has been shortened to daily; the capital lock-up period is reduced to three months from one year; and restrictions on capital remittance period has largely been removed.

What changed: The CSRC (China Securities Regulatory Commission) recently allowed QFIIs to open securities accounts in the names of actual holders or nominee holders.

In light of the market turbulence and official interventions since last June, MSCI raised two additional issues in this year's consultation paper, namely:

While things have improved, there are still 11 per cent of companies and 9 per cent of the market cap in lock-up today.

These suspensions have significantly reduced market liquidity and prevented price discovery. What changed: CSRC, together with the two exchanges, published guidelines last week to regulate and curb voluntary stock suspension.

What changed: There have been no changes to our knowledge.

Apart from the aforementioned factors, there are some additional hurdles for investing in A-shares, although they are not necessarily binding for the MSCI inclusion.

These include:

1) a lack of hedging instruments in both equities and FX;

2) the Connect Train is open only to the Shanghai market, while Shenzhen (and SME/ChiNext) market remains closed;

3) concerns about heavy government intervention since last year's rout;

4) and high market volatility and valuation.

Overall, China has clearly made progress on market accessibility, but this progress is built on existing channels, for example QFII, RQFII and the Shanghai-Hong Kong Stock Connect; while the long-awaited Shenzhen-Hong Kong Train is not yet open.

On beneficial ownership/stock suspension/anti-competitive clauses, whether the authorities have done enough to earn a tick mark rests on the judgment of the index operator.

For the non-binding factors mentioned above, they could influence the decision to the extent that the inclusion may undermine the popularity of MSCI as a benchmark, given the prevailing bearish sentiment towards A-shares.

Given these conflicting factors, we are not as confident in treating the inclusion as a high-likelihood event.

There could be a possible compromise on the outcome in two weeks' time.

This "in-between" option could be either a delay of the decision for inclusion subject to China meeting all or most of the remaining criteria, or an off-cycle decision that brings A-shares into the index before the next annual review.

It's worth reminding that the International Monetary Fund "kind of" used this option in postponing the implementation of the renminbi's inclusion in the Special Drawing Rights currency basket. We think the "in-between" option is very likely this time.

If there's an inclusion

Another possible compromise is that MSCI can progressively include A-shares in the index.

In fact, this is almost the market consensus that China will not command its full weight in the index in day one following the inclusion.

According to the proposal last year, MSCI will adopt a 5 per cent inclusion factor initially and progressively move it up to the full allotment over time.

So how would this impact capital inflows?

MSCI estimates that there are US$10.5 trillion tracking various MSCI indices globally, passive and active funds combined.

The A-shares inclusion will impact the ACWI (All Country World Index), EM and Asia indices, with combined assets under management of US$4.5 trillion.

The writer is senior emerging Asia economist at AXA Investment Managers

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