MSCI puts China mainland stocks in its indices, but there’s a catch

Ng Han Guan | AP

Investors wait for the start of the afternoon trading at a brokerage in Beijing, China, Wednesday, June 21, 2017. Global stock benchmark provider MSCI has made a long-awaited decision to add mainland China-listed shares to its widely followed stock indexes.

After years of waiting, MSCI has agreed to include China mainland stocks in its indexes, beginning next year.

It’s a big move: MSCI controls the indexes behind some of the biggest exchange-traded funds (ETFs) in the world, including the MSCI Emerging Markets ETF. Since the whole world is moving toward ETFs and passive investing, what goes in these indexes is what investors will be owning in the future.

The company is smartly holding out a carrot to the Chinese regulators: Do more to open up your markets, and we will include more of your stocks. That’s a big carrot: Chinese authorities desperately want their markets to be more widely owned outside the country.

Here’s the key points:

1) MSCI will take 222 of the biggest names in their MSCI China A International Index (out of 448), and include them in their relevant global indexes in the middle of next year. These are the largest and most liquid names in the China mainland market.

2) Rather than giving a 100 percent market capitalization weighting to each stock, they are giving each stock an initial weighting of only 5 percent of its market cap. That will greatly reduce the initial weighting of the China mainland stocks.

Why is that? Because MSCI wants the Chinese authorities to keep opening up their markets. There’s three particular things they want to see:

1) Fewer companies halting their stocks;

2) current limits on how much money can enter or leave the country for stock trades on a single day to be removed or greatly expanded; and

3) to make sure that the crucial Shanghai-Hong Kong and Shenzhen-Hong Kong Stock Connect works effectively. Those two connections are the primary path that enables investors to trade shares listed on each other’s markets using local brokers and clearinghouses.

Essentially, they are holding out a carrot to the Chinese regulators. MSCI wants the market to open up more.

“This is a small step in the right direction. For everyone to get experience — so everyone gets to know everyone — we will start small,” Henry Fernandez, chairman and CEO of MSCI, told CNBC.

Should the Chinese continue to open up their markets, MSCI will consider increasing the market cap of the existing 222 companies all the way to 100 percent. It will also consider including the remaining 226 or so companies in the future.

It’s a measured move that will build confidence in the international community and encourage even more cooperation from the Chinese.