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June 11 (Bloomberg) -- MSCI Inc.’s decision to exclude China’s local shares from its global indexes shows the nation must reduce trading restrictions to lure international investors to the biggest emerging economy.
China’s quota system for overseas money managers, which limits holdings to less than 3 percent of the country’s $3.3 trillion market capitalization, is the biggest hurdle for including mainland shares in global funds, MSCI said yesterday after a yearlong consultation with investors. The nation’s rules against same-day trading, controls on using multiple brokers and uncertain tax laws also deter funds, MSCI said.
The exclusion is a setback for Chinese policy makers seeking to boost inflows into one of the world’s worst- performing stock markets in the past five years, promote the yuan’s use in international trade and turn Shanghai into a global financial center. While the value of Chinese stocks has surged in the past decade as state-owned companies listed shares, efforts to modernize the market failed to keep pace, said Fraser Howie, a director at Newedge Singapore who wrote a book on the history of Chinese finance.
“This is probably the last big, big market which is still remarkably restrictive and limited,” Howie, the co-author of “Red Capitalism: The Fragile Financial Foundation of China’s Extraordinary Rise,” said by phone before the MSCI decision. “There’s a lot of things that can be fixed. Whether or not it will happen I am not entirely sure.”
A press official from the Shanghai Stock Exchange declined to comment on MSCI’s decision. The China Securities Regulatory Commission didn’t immediately reply to a faxed request for comment. China will expand programs that allow foreign investors to buy local shares and will scrap quotas when conditions allow, the central bank said an annual report for 2013 posted on its website today.
Instead of including China’s so-called A shares in the MSCI China Index and MSCI Emerging Markets Index from next year, the index provider will introduce by June 27 a China A International Index as a standalone benchmark gauge. MSCI will keep the shares under review over the next 12 months for potential inclusion.
MSCI’s China proposal faced opposition from international money managers including Fidelity Worldwide Investment and Templeton Emerging Markets Group, who told Bloomberg News in April that the plan is unworkable unless China removes the capital controls that limit access to local securities.
“With quota constraints, investors still can’t freely buy and sell stocks,” Ryan Tsai, an Asia equity strategist at Standard Chartered Plc, said by e-mail from Hong Kong.
Under China’s existing rules, only overseas institutions that have been awarded licenses and quotas by two different regulatory bodies can invest in local securities. The combined approved quota is about $94 billion.
The Shanghai Composite Index added 0.1 percent to 2,054.95 at the close. The gauge has tumbled 27 percent during the past five years amid slowing economic growth and concerns over government intervention into state-owned companies. That’s the biggest drop among benchmark indexes in the world’s 40 largest equity markets.
International money managers gave positive feedback on China’s plan to link exchanges in Shanghai and Hong Kong, according to MSCI, which said earlier this year it would contact between 2,000 and 3,000 global investors on its China proposal.
The bourses agreed in April to allow as much as 23.5 billion yuan ($3.8 billion) of daily trading, opening up the mainland market further to foreign investors while giving wealthy Chinese investors a route to buy Hong Kong stocks. The pilot program is due to start around October.
“China-Hong Kong connect will be a very important development,” Chia Chin-ping, a Hong Kong-based managing director at MSCI, said by phone today. “This scheme will lead fresh element into the discussion and at this stage it is on the positive side.”
The earliest date for A shares to join the MSCI developing nation gauge is May 2016, Ben Bei, an analyst at Goldman Sachs Group Inc., wrote in a report today. While MSCI’s decision wasn’t surprising, the inclusion of mainland Chinese shares in global indexes is likely to happen in the future as expanding quotas and the linking of Shanghai and Hong Kong’s exchanges reduce investor concerns, he wrote.
On top of barriers to accessing the Chinese stocks, MSCI highlighted investor concerns over the nation’s market structure and tax system.
China prevents traders from buying and selling the same stock in one day, and limits investors to using a single broker at any one time. The Shanghai exchange lacks a closing auction system, which makes it more difficult for index-tracking investors to acquire stock at the closing price.
Uncertainty over how China will apply its tax laws has deterred some investors, MSCI said. While the nation’s personal- income laws stipulate that gains from stock trading are subject to a 20 percent tax, the finance ministry and taxation bureau have exempted investors from the levy since 1994 to promote the development of the stock market.
Transaction issues and tax implications reduce the incentive for foreign investors to buy A shares, which aren’t that open anyway, Ronald Wan, chief China adviser at Asian Capital Holdings Ltd., said by phone from Hong Kong. “I can see why MSCI doesn’t want to include A shares in its indexes.”
MSCI also said South Korea and Taiwan were removed from consideration for an upgrade to developed-market status because of the absence of “any significant improvements” in areas such as the limited convertibility of local currencies and market accessibility.
The index company said it’s no longer considering a consultation process on the potential exclusion of Egypt from the emerging-market gauge, citing a “substantial” increase in foreign-currency reserves since the beginning of the year.
Tensions between Ukraine and Russia are being monitored and may result in a review of the treatment of their respective benchmarks if the situation deteriorates due to measures such as sanctions or capital controls, the New York-based firm said.
--With assistance from Aipeng Soo in Beijing and Belinda Cao in New York.