At the end of May, MSCI will be rebalancing its emerging markets index and once again the issue of the inclusion of China A-Shares will be the subject of much discussion as the provider moves to raise levels from 5% to 10%.
It will mean China A-Shares now account for 1.6% of the total MSCI Emerging Market index and according to the SPDR EMEA strategy team, this will likely result in a one-way passive flow of $3.8bn in the wake of the increase.
This is not the only potentially controversial move; at the same time, Saudi Arabia will be included in the Emerging Markets index for the first time, a move which will see the country’s stocks account for an initial 1.4% of the index before moving up to 2.7% in August.
The SPDR team believe the sizeable moves could combine for a “record one-way turnover” as funds look to rebalance in tune with the index.
It is the original decision to include China A-Shares, however, that has sparked debate within the index world and beyond. In April, Scientific Beta announced it was excluding China A-Shares from its smart beta indices. Diplomatically, it cited various technical issues for suggesting it “would not be appropriate” to include them.
Furthermore, the original decision on the part of MSCI has recently come under attack with an article in the Wall Street Journal in March suggesting the decision was politically driven. The article suggested the move was made partly due to concerns that the Chinese authorities might block attempts by MSCI to expand further in China if there was not an effective quid pro quo on A-Shares inclusion.
Understandably, MSCI stoutly defends its decision. Speaking to ETF Stream, a spokesperson pointed out that MSCI’s market classification decisions are come to after a process of gathering feedback from a broad range of market participants in a “transparent and objective” manner. This spans asset managers, brokers, consultants and custodians and well as local authorities, regulators and stock exchanges.
Moreover, the spokesperson says that decisions are made by the editorial side of the business, as opposed to the commercial side. “The outcomes of all market classification consultations are decided by MSCI’s Index Policy Committee, based on its publicly available market classification framework and a thorough analysis of the feedback gathered,” they added.
“MSCI acts as a conduit between local policy decision makers and international institutional investors to constructively communicate market feedback; it takes this responsibility very seriously.”
In the case of China’s A-Shares, they added that during three separate consultations international institutional investors outlined that they would like to see “several specific areas of improvement in the accessibility of the China-Shares market” before its potential inclusion in the MSCI Emerging Markets index.
“The ultimate decision to partially include China A-Shares in the MSCI Emerging Markets index and the MSCI ACWI index announced during MSCI’s June 2017 Market Classification Review was only following positive feedback from the investment community about the market accessibility reforms,” the spokesperson said.
On one level it is “entirely logical” that major global indices should include China, says Mark Northway from Sparrows Capital.
However, he feels there are reasons why there is general nervousness about China. “Part of the responsibility of index providers is an assessment of the rule of law, of investor protections and of governance practices – all areas in which China remains notably deficient,” he says.
He points to the experience of the UK over certain Chinese stocks on the AIM where the various failures “showed complete disregard for Western principles of governance and for shareholder rights”.
“Regulation of Chinese markets is vastly different from what global investors are used to and can involve active manipulation of data and prices,” he adds. “Changes in Chinese law are often unpredictable and retroactive. Perhaps most worryingly, the Chinese interpretation of contractual obligations is very different from the way such arrangements are viewed in the West.”
Noting that the various companies involved in index provision are for profit, he suggests it is obvious that they are exposed to commercial pressure. “It is clear that political pressure has been exerted in this case by the Chinese authorities,” he says. “What we do not know, and will probably never know, is whether it had any impact.”
And yet, it is also fair to suggest that decisions on index composition face similar pressures to those of the ratings agencies when it comes to a country’s debt rating. In the ratings world, Peter Sleep, senior investment manager at 7IM, points out, for instance, that it has also long been assumed that S&P and Moody’s have previously have been on the receiving end of questions regarding how their country ratings are affected by the US debt pile.
Moreover, the importance of China to the global economy makes it difficult for the index companies. “China is very hard to ignore,” he says. “There will also be pressure on the other index providers like JP Morgan and Barclays Bloomberg.”
As will be clear at the end of May, to an extent, this is already a settled matter. Given the importance of China to the emerging markets, the importance of China A-Shares to the emerging market index – and their weighting – is also sure to increase in the years to come.
After all, an important point about the MSCI decision is that in its wake nine Chinese ETFs were approved by regulators last year compared to one that existed previously. That is perhaps the most significant pointer to the future.
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