MSCI, originally Morgan Stanley Capital International, provides several global stock indexes. The mainland Chinese stock market already makes up 26 percent of MSCI's Emerging Market Index. This primarily includes stocks listed overseas or those listed in currencies other than the yuan. Including China's A-shares could bring the ratio up to 40 percent, though MSCI has proposed a phased entry starting with a small percentage of those stocks.
For China, getting the MSCI index to include its A-shares, which are listed in yuan, would support the rise of the yuan in global financial markets. More important, it would help Beijing meet its goal of integrating further with the international financial community by opening a larger part of the mainland exchanges to more stable money. Most of the major holders of benchmark index funds are large institutional investors, such as pension funds, that would have a longer time horizon for investments. In fact, among MSCI's outstanding concerns are that China has not fully implemented the quota systems from overseas investments and that there are too many constraints on Qualified Foreign Institutional Investor programs. All told, inclusion in the MSCI index could attract hundreds of billions of dollars, if not considerably more in the long run, to Chinese stock markets over the next decade.
The absence of large institutional investors holding stocks for the long term in the Chinese stock market leads to wider volatility and encourages speculative behavior from retail investors. MSCI indexes are usually bought by more long-term funds, which rarely make short-term decisions — a fact that could help reduce some of Beijing's biggest concerns about its stock markets: speculation and volatility.
China has not completely addressed all of MSCI's concerns since its last rejection in June 2015, and a few new problems have arisen, but overall Beijing has shown a consistent willingness to implement reforms to support its goals. In the past year, China has liberalized the quota allocation process for its Qualified Foreign Institutional Investor program, which allows licensed international investors to trade A-shares; limited the length of voluntary trading suspensions; and removed some of the restrictions on repatriation limits. MSCI noted, however, that there are four key issues that need to be addressed. Two of them concern the effective implementation of new policies announced by China this year, including May's announcement on trading suspensions, and the other two require additional policy changes.
The first key issue is China's monthly repatriation cap of 20 percent of a fund's net asset value (at previous year). Preventing quick capital flight and managing market turmoil has been a consistent theme emanating out of Beijing since last year, when the volatility of Chinese stock markets increased significantly. China would like to prevent a massive, rapid outflow of capital from foreign investors for the same reasons that it would like to prevent it from domestic investors. Progress in removing or reducing this restriction is likely, but this is one area where Beijing will probably move with caution.
The second major concern — one that emerged over the past year — is the de facto veto mechanism China may try to create by requiring that the Shanghai and Shenzhen exchanges preapprove attempts by financial institutions to launch financial products that include A-shares on any global stock exchange. This effectively limits the number of financial products, such as ETFs, that include A-shares that international investors have access to. Before tackling this issue, Beijing may try to create a combined super-regulator akin to the British Financial Services Authority. Doing so would take some time; it would require eliminating overlapping authorities and regulations and empowering the new entity with legal and enforcement capacity.
Though MSCI decided not to add Chinese A-shares to its index, the implications are not as dramatic as some news headlines have made them out to be. The delay does, however, reflect the uncertainty among international financial markets as to whether China is committed to continual economic reforms, especially capital account liberalization. The markets' doubt is well founded, but Beijing's deliberate pace has more to do with priority than with capability. After all, China showed its willingness to reform when the yuan's status as a reserve currency was on the line. Late last year, the International Monetary Fund agreed to include the yuan in the basket of currencies that make up its Special Drawing Rights, a club that carries more political and symbolic value than does inclusion in the MSCI Emerging Markets Index. The impetus for China's government to fulfill the IMF's requirements was greater than it is to satisfy MSCI's concerns. Besides, addressing the concerns of international investors requires more real economic reforms than addressing the political realities surrounding the IMF's decision did.
Beijing will go ahead with the changes necessary for inclusion in the MSCI Emerging Markets Index, but they will be lumped in with its other planned economic reforms. Since MSCI decides on potential additions annually — not every five years like the SDR review — there are more opportunities for consideration, and thus less urgency to the reforms. China's broader economic and financial reforms will continue at Beijing's pace, not the dictated pace of global financial institutions.