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MSCI starts closing its open door to China

MSCI Inc is showing new toughness on adding domestic China shares into its global benchmarks. The move will better protect investors and may dampen a political backlash in the US after it already opened the door to more Chinese stocks. The new, almost insurmountable conditions will effectively start closing it on further entries.

Inclusion by the world's most tracked index provider gives companies a de facto stamp of approval to passive funds and a feeling of cover to active investors. Over the past year, New York-based MSCI has been increasing the so-called inclusion factor of mainland companies to its indexes. On Wednesday, the factor reached 20 per cent , bringing the total to 472 China A shares. This means that domestic Chinese stocks now make up 4.1 per cent of the all-important MSCI Emerging Markets Index and 0.5 per cent of the MSCI All Countries World Index, potentially funnelling US$6.7 billion into Chinese A shares, double the total in August, said Thomas Taw, head of APAC iShares investment strategy at BlackRock Inc.

MSCI has pushed back against criticism by some US lawmakers that the composition of its indexes is diverting billions of American investment dollars into Chinese companies, amid the trade war and concerns about security and human rights. Two US senators introduced legislation last month to prevent the retirement savings of federal workers from going to China. But with its latest round of inclusions now accomplished, MSCI is raising the entry bar.

Four conditions will need to be met for new additions: First, MSCI wants China to approve the use of more hedging tools and derivatives. China has expanded the number of stocks eligible for margin trading this year, say HSBC Holdings analysts, and is adding CSI 300 index options to existing products. How many more hedging tools China will approve is an open question, given how much of the 2015 market crash was blamed on derivative products.

The next two conditions, concerning reforms on the trading links between Hong Kong and mainland exchanges, are just as difficult. MSCI wants foreign investors to be able to trade when Hong Kong markets are closed for holidays but China's remain open. It also wants the authorities to allow omnibus trading accounts, where a single order can be made on behalf of multiple clients. The workings of the "Connect" trading links involve not just Hong Kong Exchanges & Clearing Ltd, which may do what MSCI wants, but require approval from the Shanghai and Shenzhen exchanges and China's government. Beijing has a history of controlling the market-opening process and these kind of changes could take years.

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The fourth condition is an even bigger ask, given the slow pace of reform: MSCI wants trades settled in a couple of days, like elsewhere, rather than instantly as in the mainland. Immediate deadlines are daunting for investors in the US or Europe, for instance, who don't have that kind of live trading and operational support during Chinese business hours. Hong Kong's stock exchange operator is working on a blockchain settlement for the trading pipe that may solve some of these problems, but this could take a long time.

These changes are needed. Domestic Chinese stocks are volatile. Retail investors make up the bulk of trading in A shares and are prone to flip on any signs of bad news. The standard deviation of returns for the CSI 300 large-cap index has been 38 per cent since 2006, more than three times higher than the 11.6 per cent for the S&P 500, according to Gavekal Dragonomics data. Institutional investors brought in by MSCI and other indexes are exposing institutional investors to a mostly domestic, retail-focused market, a big difference from the Hong Kong-listed Chinese shares that they had before MSCI's addition of mainland stocks in June 2018. Unlike the domestic Chinese stock markets, where mom-and-pop investors make up more than 80 per cent of turnover, foreign investors account for two-thirds of Hong Kong trading.

Leverage is a fact of life in Chinese stock trading. In 2015, margin loans were a problem: The huge portion of borrowed money magnified gains and losses, and led to a bust and a government-engineered rescue of the stock market. Last year, the practice of major shareholders pledging shares as collateral for loans resulted in a downward spiral when lenders dumped stock as prices fell. Meanwhile, Chinese state firms, which make up a large portion of listed stocks, are often asked by Beijing to do "national service".

MSCI is right to add stricter requirements for inclusion, as it has no screening mechanism for individual stocks and bases entry on market capitalisation and turnover. Foreigners held as much as 3.3 per cent of China's total A-share market value from around 2 per cent at end-2017; much of that increase has been attributed to MSCI. The tighter stance acts as another filter of protection for those masses of investors, even if China inflows slow. BLOOMBERG

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