China A-Shares: Not Ready for Prime Time

On June 14, the index provider MSCI announced it would not include mainland Chinese shares in its index of emerging market stocks. The so-called China A-shares were excluded for the third year in a row.investing in china

This is a big deal. First, China’s stock market is the second largest in the world. Add to that the fact that $1.5 trillion is benchmarked to MSCI’s emerging market index.

MSCI in effect said China A-shares were not ready for prime time. But it did say China had taken “significant steps” towards inclusion.

Despite the progress made, MSCI cited some specific factors for the exclusion of China A-shares.

Chinese Regulations Slowing Fund Flow

One factor is investors’ ability to move funds easily in and out of the mainland market.

Investors even had problems getting money into China for investment. But rules adopted in April seem to have accelerated the whole process of QFII (Qualified Foreign Institutional Investor). QFII involves approval by Chinese authorities for foreign funds to invest in mainland stocks.

A bigger worry expressed by MSCI is with getting money out of China. The country’s capital controls limit investors to repatriating no more than 20% of the net asset value they have invested in any one month. MSCI says this limit must be removed or substantially raised.

Another obstacle is China’s rule on financial products. Currently, China says it must approve all financial products that include China A-shares. That rules applies even if the product trades on foreign exchanges. Obviously, MSCI is not going to cede control of its own products to Chinese bureaucrats.

There is another and much more serious problem in my eyes: trading suspensions.

Stock Suspensions and Liquidity

MSCI wants to see if China will enforce its new stock suspension rules. The new rules limit suspensions to no more than five days.

It was not uncommon in China to see stocks suspended for trading for months or even years. Under the old rules, Chinese companies did not even have to ask for permission from regulators to halt trading in their stock.

A number of mainland Chinese companies employed this tactic during the crash of the Chinese stock market last year. In fact, at one point, half the stocks on the market weren’t even trading!

The “logic” here from these companies is that their stock would avoid the rout and would resume trading when conditions were more benign. With the Chinese markets still down 40% from their bubble peak, some stocks are still suspended.

One final concern is China’s “national team” coming in and supporting stock prices during market turmoil. For me, that is a minor concern. All countries do it, including the U.S.

China A-Shares Dust-Up: What It Means

I believe the thumbs down on China A-shares from MSCI will be a good thing for investors in China, both foreign and domestic, in the long term.

The chief economic adviser at Allianz, Mohamed El-Erian, said in a tweet that we will see the “World Trade Organization” effect . . . that is, global standards improving the functioning of domestic markets.”

That bodes well for anyone investing in any of the China A-shares-linked ETFs here in the U.S.

These include the following ETFs: Deutsche X-trackers Harvest CSI 300 China A-Shares ETF (NYSEArca: ASHR), MarketVectors ChinaAMC CSI 300 ETF (NYSEArca: PEK), SPDR MSCI China A-Shares IMI ETF (NYSEArca: XINA) and the CSOP MSCI China A International Hedged ETF (NYSEArca: CNHX).

Even though I am bullish on China and invest in Chinese stocks, I’m not really interested in any of these.

The reason is that the China A-shares index is filled with companies I don’t want to own – about 37% of the index is financial stocks. Throw in some debt-ridden state-owned firms and I’ll pass.

Even though it’s also high risk, I’d rather own the MarketVectors ChinaAMC SME-ChiNext ETF (NYSEArca: CNXT). This ETF tracks the 100 largest and most-liquid stocks on the Small and Medium Enterprise board and the ChiNext board of the Shenzhen Stock Exchange.

Shenzhen is the Silicon Valley of China and the most dynamic “new economy” stocks are listed on those exchanges.

Having MSCI pushing for global standards in China will only improve the reporting and transparency of China’s growth companies listed on these exchanges. That will lower the risk profile on CNXT over the long-term.

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