China's market surge could pose problem for investors

Institutional investors might soon have occasion to ponder what the opposite of catching a falling knife is.

A metaphor appropriate for markets moving north rather than south could come in handy beginning June 9, when MSCI Inc. announces whether it will include a fraction of China's surging A-shares market in its indexes.

A decision by MSCI to add A shares to its main indexes now would force benchmark-aware asset owners to buy stocks that are looking very pricey.

On May 26, FTSE Russell, MSCI's biggest rival, took a half step in that direction, announcing “transitional” emerging markets indexes with 5% exposure to A shares that clients can opt to use instead of FTSE's standard emerging markets indexes.

In contrast to launching parallel indexes, MSCI officials are considering changes to the firm's main emerging markets and regional indexes. BNP Paribas Corporate & Institutional Banking estimates those changes could result in $22 billion of A-shares purchases, assuming active managers target the weightings MSCI has proposed, said Winner Lee, the firm's Hong Kong-based Asia equity and derivatives strategist.

A year ago, MSCI's first look at the question of including 5% of the $7 trillion A-shares market in MSCI's investible universe concluded with a decision not to do so, amid global manager concerns that the quotas needed to invest directly in Shanghai and Shenzhen remained too difficult to obtain.

Since then, the A-shares market has emerged from a five-year slumber to post the strongest gains of any major exchange over the past year, driven in part by widespread margin borrowing by retail investors, who account for more than 90% of that market's daily turnover.

The Shanghai Stock Exchange Composite index has risen 126% to 4,611.74 in the 12 months through May 29.

The bull market has picked up steam even as China has continued to retreat from the double-digit growth that powered the global economy for much of the previous decade.

China's equity market has become a “distant cousin” to the country's economy, with no strong relationship anymore between the two, Ruchir Sharma, managing director and head of emerging market equities for Morgan Stanley Investment Management in New York, said in a May 21 presentation to institutional investors in Singapore.

MSCI officials have said they take overseas investors' ability to access a market, rather than valuations, into consideration when deciding whether a market should be part of the investible universe.

On that score, China's regulators have opened a number of doors to foreign investors in the past year. Most recently, on May 22, regulators announced the July 1 launch of a much-discussed “mutual recognition” scheme that would allow mutual funds registered in Hong Kong to be sold to investors on the mainland, and mainland-registered funds to be bought by investors in Hong Kong.

Roughly eight months earlier, the Shanghai-Hong Kong Stock Connect program went live, with quotas set for “northbound” investment flows from Hong Kong to Shanghai and “southbound” flows from the mainland.

Those recent initiatives are in addition to the qualified foreign institutional investor program launched 12 years ago and the renminbi qualified foreign institutional investor program launched 3½ years ago. The former had distributed $73.6 billion in quota capacity to 268 investors as of April 28, just less than half the program's current ceiling of $150 billion. The renminbi program had distributed 364 billion renminbi to 121 investors.

Some observers believe Chinese regulators have expanded access for overseas investors enough over the past year to get A shares into MSCI's investible universe.

“We've been seeing regulators bend over backward to really accommodate inclusion,” said Charles Salvador, director, investment solutions, with Z-Ben Advisors, a Shanghai-based consultancy on financial market business opportunities in China.

Others give China credit for trying, but predict this still won't be the year.

The lack of full currency convertibility, constraints in dealing with securities, and unresolved tax issues will leave many asset owners hesitant about adding A shares to their portfolios just yet, noted Stuart Leckie, founder and principal of Stirling Finance Ltd., a Hong Kong-based research and consulting firm focusing on the pension fund and asset management industry in Hong Kong and China.

Whether MSCI acts this year or next, market veterans insist it's time for investors globally to recognize that China will command a much bigger chunk of their allocations over the coming five to 10 years, and to begin thinking through the issues they'll have to grapple with to get that exposure.

Asset owners should be doing their due diligence with regard to how much China exposure they should have in line with their goals of capturing the global equity risk premium, said Qi Wang. Mr. Wang was head of MSCI's China research team before leaving earlier this year to found China Forward Capital Group Ltd., the Hong Kong-based marketing arm of alternatives firm Shanghai MegaTrust Investment, where he is a partner and advisory director.

In light of China's contribution to global growth, arguments can be made that asset owners' typical 2% portfolio weighting to China through exposure to Hong Kong-listed stocks and the American depository receipts of Chinese companies represents a dramatic underweight, said Mr. Wang.

At present, valuation issues can reasonably lead asset owners to make a secondary decision to underweight a strategic allocation to China's market, he said. But taking a hard look at what that high-level strategic allocation should be could prove crucial to an investor's long-term success, he added.

Other market veterans echoed that point, noting that an MSCI decision to include an initial sliver of A shares to its indexes could prove important even if most asset owners conclude the market is too pricey for the moment.

“The opening of China's domestic capital markets and eventual inclusion of A shares in global benchmarks raises the question of how much strategic exposure investors need to China,” said Aaron Costello, a Singapore-based managing director on the global research team of investment consultant Cambridge Associates Asia Pte. Ltd. But that question “is separate from how much China do they need today,” Mr. Costello added.

Given the current market dynamics, now is not the time to ramp up exposure to the A-share market, he added. In that sense, from the perspective of immediate investment flows, MSCI's decision is likely to be “a non-event,” even if the symbolism of A shares inclusion is significant, said Mr. Costello.

Institutional investors might want to boost their A-shares exposure if conditions were normal, but “conditions are not normal,” agreed Sterling Finance's Mr. Leckie. “This boom is about to become a bubble, and all bubbles get bigger and ultimately burst.”

Morgan Stanley's Mr. Sharma, a long-time China bear, pointed to the unprecedented levels of margin debt Chinese retail investors have taken on recently as evidence that China's government is actively using the stock market as a lever to lift an economy being dragged down by excessive debt.

Mr. Sharma presented research showing countries where private debt as a percentage of GDP rose by 40 points or more over five years inevitably suffered drops in economic growth of 50% or more for the five years that followed. He said China — with the debt-to-GDP ratio up 82 points over the past five years — is already in the process of a sharp slowdown.

Asked if additional inflows to China's A shares from overseas investors, on the back of a positive decision by MSCI on June 9, could help alleviate that debt burden, Mr. Sharma predicted any lift would be marginal. n