It is an important week for the Chinese stocks. The Morgan Stanley Capital International (MSCI), will decide whether or not the Chinese A-shares will finally be included in its international stock indices, MSCI China and MSCI EM.
China’s A-share stocks refer to Renminbi denominated stocks traded at Shanghai and Shenzhen stock exchanges. The market value of the A-shares climb up to $6.8 trillion.
The MSCI has refused to include the Chinese stocks in its international benchmarks because they are subject to strict capital controls by the Chinese government, trading restriction and long interruptions in times of bearish market.
Three factors are determining in MSCI’s judgment to include Chinese stocks in its indices.
First, the accessibility of the A-shares by international investors and their freedom for fund repatriation. Investors should be given the mobility to repatriate their funds at desired times. Chinese government frequently employed trader-unfriendly measures such as trading suspensions and restrictions on the sell-side to cool down the market pressures on times of global sell-off. This aspect is highly in disfavour of the A-shares' candidacy for an international benchmark, as the inclusion of Chinese stocks would mean that many funds would have to invest in these stocks to track the global benchmarks and they should be guaranteed that their funds would not be stuck in the Chinese system at times of market anxiety.
This brings us to the second rule, which is an effective implementation of trading suspension rules.
Finally, the determination of the pre-approval requirements regarding the underlying assets to the Chinese A-shares.
Of course, not all stocks will be a fit for the MSCI’s global indices. The MSCI will consider 169 A-share stocks which could be potentially included in the MSCI indices, compared to 448 companies considered in 2016.
A fourth rebuff is possible and highly probable as Morgan Stanley (NYSE:MS) analysts estimate the probability of inclusion slightly above 50%. Golden Sachs analysts revised this probability down to 60% from 70% a year earlier.
Minor nominal impact, major sentiment impact
The narrowing scope of eligible shares means that only China’s most competitive stocks will be in examination this week and some may pave their way to the MSCI's most popular international indices.
Yet, even in case of a positive outcome for all of the stocks eligible for inclusion, the Chinese A-share stocks will represent roughly 0.5% of the MSCI EM index and less than 2% of the MSCI China index. Therefore, the nominal impact would only be minor in terms of the overall index values.
However, the psychological impact would be determinant.
Although China’s rising overseas businesses, increasing global influence and the government’s efforts to reform the financial markets are meant to provide international investors a more business and trading friendly conditions, the skepticism regarding the Chinese onshore stocks remained relatively high since the Shanghai Composite wrote-off nearly half of its value following the mid-2015 sell-off. Ever since, the highly leveraged stock index has been considered as unstable and too volatile by long-term solid investors.
This is why, the A-shares’ inclusion in the MSCI indices would increase their international recognition and temper the negative reputation of worthy mainland shares. Hence, this would be an important step for the future of the Chinese stock markets, even though the financial extent of a minority of A-shares inclusion will be insignificant in the short-run.
In the long-run, being part of the MSCI means increased and relatively stable inflows in the Chinese stocks, which will in turn help decreasing the volatility in their values and restore long-term investors’ confidence in well-performing stocks operating in the world’s biggest emerging market.