Beijing and MSCI deadlocked on A-shares

Momentum has been fast gaining pace towards China A-shares being included in MSCI’s global emerging-market indices in recent months, or so it seemed. But the index provider decided yesterday not to include mainland stocks, despite most of the key hurdles being removed – and it may be quite some time before it gives the green light.

The problem, say market observers, is that Beijing will be reluctant to remove the two remaining obstacles – namely, capital repatriation limits under the cross-border QFII scheme and stock exchange restrictions on product approval.

This is not least because capital controls, which would affect the withdrawal of money from China, fall under the remit of the central bank and the foreign exchange regulator – not only the securities watchdog.

“Any process going forward will be very slow,” said a senior executive at a Shanghai-based private fund firm who asked to remain anonymous. “The MSCI wants results from the mainland regulator, but the regulator may not as cooperative as before. They tried, but the index provider said they are not doing enough.”

A major issue is that of repatriation limits under the qualified foreign institutional investor (QFII) scheme.

Despite China’s relaxation of the QFII quota system in February, MSCI questioned the effectiveness of the policy changes. And foreign fund managers and institutions were not convinced due to the continuing limits on capital repatriation. QFII investors can only withdraw up to 20% of the net asset value of their onshore investment as of the previous year-end.

This means foreign mutual and pension fund managers may not able to repatriate sufficient capital to be able to manage products properly, said Remy Briand, MSCI’s global head of research, after the decision was announced yesterday morning Hong Kong time. Hence the limit must be substantially increased or, ideally, removed, he noted.

Yet capital account controls are no longer a matter for the China Securities Regulatory Commission (CSRC), but rather the People’s Bank of China and the State Administration of Foreign Exchange.

And it is very unlikely that the FX regulator would remove capital flow limits to satisfy MSCI requirements, noted Iris Pang, Hong Kong-based senior economist for Greater China at Natixis.

“Any factors that will add to capital outflow pressure are unwelcome by Beijing,” noted Chi Lo, senior Greater China economist at BNP Paribas Investment Partners. “It is very unlikely that Beijing will remove capital flow quota in the short term.”

Meanwhile, MSCI has also said China must resolve the product ‘pre-approval’ requirements imposed by the Shanghai and Shenzhen bourses. These restrict foreign financial institutions from launching new products linked to indices containing A-shares, such as index fund derivatives, based on the MSCI EM benchmark. Such products would risk trading disruptions if an exchange withheld licensing approval for MSCI’s EM index.

Again, this change is not likely to take place in the short term, although MSCI said it was in talks with the mainland authorities and hoped to propose a solution to this issue.

The decision on product approvals is down to the CSRC, but the watchdog is concerned that index and futures traders could use such financial products for short-selling A-shares overseas, said the anonymous fund firm executive in Shanghai.

So how long will it take A-shares to enter the EM indices? The MSCI said the pace of reform was down to the mainland authorities and that it could not make assumptions as to when that could happen.

Beijing said it would need time to address the two remaining hurdles. And MSCI said it, too, needed time to monitor the implementation of new rules on voluntary trading suspensions, which were issued by local exchanges in late May.

The index provider pointed out that only 0.2% of stocks, in terms of numbers, are currently suspended in the EM universe, versus some 6-10% of A-shares. Briand said MSCI wanted to see the number of suspended mainland stocks fall but that it had no specific target.

MSCI has retained A-shares on the review list for 2017 but said it would be flexible as to the timetable for the inclusion decision if China were to resolve these hurdles.