ET In The Classroom: What inclusion of China 'A' shares in MSCI index means for markets

Over the past week investors and fund managers were on the edge, fearing that money may move out of India to China. The concern owes its origin to a possible rejig of the MSCI Emerging market index — a benchmark widely tracked by fund managers across countries – to include mainland Chinese stocks in the index. An inclusion of Chinese stocks would tilt fund allocation by asset managers in favour of China – a move that could hit sentiments on Dalal Street.

There was a sigh of relief when MSCI – the organisation that provides the MSCI range of indices – postponed its decision. But this is no reason for investors in India to relax because MSCI can now include Chinese stocks as soon as they receive approvals from Chinese regulators. Indeed, such inclusion may even catch investors unaware as MSCI can go ahead to reconstruct the index without the customary meeting with fund managers. ET takes a closer look at the possible implications:





HOW THE INCLUSION OF CHINA ‘A’ SHARES IN MSCI EM INDEX IMPACT INDIAN EQUITIES? (‘A’ SHARES ARE YUAN DENOMINATED MAINLAND STOCKS)

Outflows from India is linked to the weight of China ‘A’ shares in the EM Index. Experts think this will happen in phases. Initially, China will have 1% weight while India’s weight may come down by 0.3% from 7.2%. Passive funds — which blindly follow the index and hold 13% of assets owned by foreign portfolio investors (FPI) — would churn their portfolio in favour of China. Active funds, which are overweight on India, may also tweak their strategy.

WHY IS CHINA SIGNIFICANT FOR GLOBAL FUND MANAGERS?

The Mainland China stock market is the second-biggest in the world with market capitalisation of $9 trillion. Understandably, China would have a weight higher than India in the MSCI Index. This would influence allocations by index funds, exchange traded funds, mutual funds, pension funds and sovereign wealth funds.

WHAT IT TAKES TO MAKE IT TO THE MSCI INDEX?

MSCI weighs factors like economic development, size of the equity market, liquidity, and market accessibility to global investors to decide whether a country can find a place in any of their index. Since the indices concern global fund managers, aspects like flexibility on foreign ownership, ease of capital flows, operational efficiency and stability of institutions are also considered.
WHAT ARE THE REGULATORY HURDLES FOR MSCI TO INCLUDE CHINA IN THE EM INDEX?

Total investments by foreign funds is capped at $328 billion. Also, there is daily FII investment limit of $2 billion — a condition that dosn’t exist in any EM — as well as exposure limits of offshore funds in each stock. If net buying by foreign funds on a single day crosses $2 billion, trading is suspended for the next day. Besides, there are issues related to trading settlements, and mismatch in holidays between the Hong Kong and the Shanghai exchanges. Foreign funds want some of these rules to be relaxed.

WHAT ABOUT INDEX PROVIDERS? WHAT ARE THEY DOING TO INCLUDE CHINA?

FTSE — another index provider and a competitor to MSCI — has introduced two transitional indices which include China ‘A’ shares. It will be merged with standard FTSE EM index once the Chinese regulator eases trading restrictions. Till then, fund managers may allocate money based on these transitional FTSE indices. Vanguard Group, which oversees $3.3 trillion in assets as the largest US MF, said it would add mainland shares to its $69-billion EM index funds. Experts observe that MSCI may launch similar product to include China ‘A’ share till Chinese regulators ease the rules.