MSCI says no to China

Last night, MSCI, the world’s largest indexing firm, announced that it will not be adding China’s A shares as constituents of its widely followed EM index.

It has also made a number of comments which were of interest to global emerging funds following Pakistan, Nigeria, Argentina and Saudi Arabia.

In summary:

1. For passive EM funds, the MSCI EM index is the most significant globally by far, with around $1.5 trillion of indexed investment. For active investors, any change in the weighting of the index (which they are benchmarked against) forces them to reassess the composition of their portfolios.

2. MSCI pointed to a number reasons behind their decision regarding China’s A share market, the main one perhaps being capital mobility. First and foremost, the monthly repatriation limit (the amount of his total capital the investor is able to withdraw from the market during one month) of 20% is considered too low, especially should the fund be faced with redemptions. The time-consuming and opaque process of receiving approval for a quota (allowing investors to invest in Chinese stocks) is also a factor. On top of this, the need for preapproval of financial products on foreign stock exchanges that are linked to A-share indices has not been yet addressed.

It is important to note that China is already the largest component of the MSCI EM Index, making up over 25% of the index. This is made of up of ADRs of Chinese companies listed in NY or Chinese shares quoted in Hong Kong. The domestic (A-share) stock market – the largest in the world after US – is not included in the index.

3. MSCI announced that Pakistan will be reclassified as an Emerging Market. Given its current account deficit and need for capital to drive steady growth, many observers agreed that Pakistan was the biggest winner from yesterday’s announcement.

4. Argentina will be reviewed for a potential upgrade. In December 2015, the Argentinian Central Bank abolished foreign exchange restrictions and significantly relaxed the capital controls that have been in place for a number of years. These changes have resulted in a floating currency, the elimination of cash reserves and monthly repatriation limits on the equity market, as well as a significant reduction in the capital lock-up period for investments.

5. Nigeria may be removed from MSCI’s Frontier Markets Index and reclassified as a stand-alone market due to capital mobility issues. This may even come as soon as November this year. Early last year its Central Bank pegged the local currency to the US dollar resulting in a sharp decline in liquidity on the foreign exchange market. Hence, the ability of international institutional investors to repatriate capital has been significantly impaired to the point where the investability of the Nigerian equity market is being questioned.

6. MSCI said that it welcomes the recent market enhancements announced in Saudi Arabia, which opened its market for the first time to foreign investors last summer. These include changes to the rules for qualified foreign investors, settlement cycle of listed securities, elimination of the cash prefunding requirement and the introduction of proper delivery versus payment. Many of these are on course to be implemented by mid-2017 and will bring the Saudi equity market closer to EM standards.

Sources: MSCI, FT, Natixis

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