MSCI inclusion of China stocks – risks on the horizon

MSCI’S inclusion of some China stocks into its global emerging markets benchmark index may have a small impact, at this stage, on regional markets but risks have appeared on the horizon.

“A direct transmission channel for the contagion from financial market volatility in China into world markets is now open.

“So far, China’s regulators have been able to keep a lid on any problems arising but financial market observers have been edgy about potentially uncontrollable issues emanating from high levels of debt and unquantifiable risks from a very large shadow banking sector,’’ said InterPacific Securities head of research Pong Teng Siew.

China’s debt to gross domestic product ratio rose to 277% at the end of 2016 from 254% the previous year, Reuters had said, quoting UBS.

The shadow banking industry, an area where Chinese authorities are working to reduce risk, is estimated at US$8.5 trillion by Moody’s Investors Service. Shadow banking refers to financial activities among non-bank financial institutions outside the scope of regulators.

“The medium to long-term implications will be meaningful as global investors’ portfolio rebalancing will have to take into account more Chinese stocks; their weighting in the index will likely be higher in the years ahead, in tandem with the depth and breadth of equity markets,’’ said Socio Economic Research Center executive director Lee Heng Guie.

“China will face the risk of capital reversal should global investors tweak their portfolio rebalancing on any risk perception associated with macroeconomic and financial instability. The bloated debt remains a top concern,’’ said Lee.

Pull factors For a start, just 222 large-cap shares in the world’s second largest stock market will be included, accounting for a 0.73% weighting in the MSCI Emerging Markets Index. In making that decision, MSCI appears to have forgotten its doubts about China, said Bloomberg, which warns of exposing unknowing foreign investors to elevated risks in the Chinese market.

MSCI had last year cited the tendency of Chinese companies to halt trading whenever market conditions worsened or bad news came out as a basis for rejection. Yet this year, it “evidently had no qualms’’ that about 10% of A-share companies had voluntarily suspended themselves, said Bloomberg.

Another obstacle cited last year was the ability to sell stock and repatriate funds to investors, something that is critical for index investors. And yet this year, MSCI gave almost no mention of capital-mobility issues, even as China’s crackdown on capital outflows has many companies and investors fretting, said Bloomberg.

A pull factor for greater participation of foreign institutional investors would be China’s stepping up the liberalisation of its financial markets such as in foreign ownership and free capital mobility, said Lee.

This is coupled with the “internationalisation” of the yuan accompanied by a sustainable, restructured economy and corporate sector including state-owned enterprises.

“It should start to sap some strength from the other MSCI emerging markets although the impact would be small, given the limited inclusion,’’ said Etiqa Insurance & Takaful head of research Chris Eng.

The MSCI Emerging Markets Index consists of 23 countries spanning the Americas, Europe, Middle East and Africa as well as Asia. They represent 10% of world market capitalisation. “China stocks will continue to grow in their importance in global benchmarks and investment arena.

“Emerging markets, including Malaysia, will have to increase their appeal to investors, given increased competition from China in years to come.

“Strengthening economic and financial fundamentals is vital for any country to sustain its appeal to foreign portfolio flows,’’ said Lee.

“In addition to factors that appeal – economic and commercial interests as well as corporate growth prospects – foreign investors also emphasise the importance of other factors such as perception of regulatory risk and governance,’’ said Lee.

“Index funds passively tracking related indices may have no choice but to invest in Chinese shares that have been admitted as components of such indices.

“The potential effects of US Fed rate hikes now remind us of global or regional crises that have previously unfolded as rate increases are gradually engineered,’’ said Pong.

Fed rate hikes can reverberate through Asia as capital is lured to rising yields in the US, sparking financial market volatility and driving up borrowing costs for the region, Bloomberg had said.

And South-East Asia, in particular, is often vulnerable because of dollar-denominated debt serviced in local currencies.

Currency turmoil and depression of emerging market currencies are also potential effects, possibly made more complicated due to the contagion that will now spread over a wider area.

Columnist Yap Leng Kuen welcomes but is also cautious of the “dragon’s roar” in Chinese stocks.