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Buyer beware -- MSCI is not a quality guarantee

Bending of index rules in hope of Chinese reforms is bound to lead to disappointment

| China
MSCI opted to compromise on standards to go with investors who wanted to be in China. (Photo by Akira Kodaka)

Could MSCI, the financial market index company, live to regret its loudly trumpeted move to include Chinese domestic shares in its indexes starting June 1?

The momentous step will compel fund managers tracking or benchmarking against MSCI's global emerging markets index and others to buy Chinese domestic shares for the first time. An estimated $1.7 trillion is invested in funds linked to the MSCI Emerging Markets Index alone.

MSCI however itself admits that the Chinese authorities have yet to fully address a string of technical and regulatory issues that for years held the index provider back from including Chinese domestic stocks. It is going in regardless of its previous misgivings.

Despite the appeal of investing in the world's biggest emerging market and its second-largest economy, investors following MSCI's lead must do so with their eyes open. Caveat emptor still applies to China, MSCI or no MSCI.

Leave aside the dubious quality of listed companies' financial reports and regular government interference in everything from what investments companies can make to the prices of initial public share offerings. That all matters, of course, but instead consider a few more workaday market structure issues.

Chinese companies suspend trading of their shares almost at will, leaving investors unable to trade their stock for extended periods -- often months, sometimes years. After previously noting this many times as a reason not to include Chinese domestic shares in its indexes, MSCI still acknowledges the problem but has chosen to look the other way. It offers only the assurance that China will "consider additional measures to address the issue."

Another problem is the way China's draconian capital controls operate to control the movement of the yuan, restricting cross-border currency transactions. Here too MSCI is simply choosing to plunge ahead even though Beijing's restrictions are formidable enough to push the company into breaking up its inclusion of domestic shares into two phases -- June 1 and Sept. 3 -- to allow foreign investors to have time to catch up on their purchases.

A few years ago when the International Monetary Fund was weighing whether to include the yuan in its Special Drawing Rights basket for global reserves, it laid out very specific requirements, backed up with research. After careful consideration of the issues and technical analysis, the IMF proceeded to ignore its own standards and add the yuan to its basket anyway. Today, if we exclude Hong Kong, the use of the yuan remains limited: it is slugging it out with the Danish krone in rankings of currencies employed in international transactions.

Why would institutions like the IMF or MSCI so willfully ignore their own researched and reasoned technical financial standards?

The cynical view, especially with regards to MSCI, holds that they are bending to pressure from China to relax their rules. When China was repeatedly rejected from MSCI inclusion, state media went on nationalistic tirades about the lack of wisdom of such standard-setting bodies. Beijing also placed enormous pressure on the IMF in the lead-up to its decision on adding the yuan to its currency basket.

Though largely symbolic, such recognition matters enormously to China's status-obsessed government, which views almost every decision as either a potential slight or as confirmation of its brilliance.

The likely reality is only slightly less cynical. Foreign institutional investors wanted to be in China and rather than push for further change or hold off until MSCI's technical standards had been met, the company opted to take China on an "as is" basis. In its original inclusion announcement last year, MSCI carefully noted investor requests for inclusion, providing the company plausible deniability that it was acting at the recommendation of its clients in ignoring its own technical standards.

For years, investors and policymakers alike have been expecting China to change: Its capital markets would open up, trade barriers would fall and state-owned enterprises would shrink in importance. For years, China has ignored the pleas of foreign companies and governments and set the terms of trade; investors and foreign authorities still face a simple choice of either taking China's terms or not engaging.

Fund managers investing capital in the Chinese companies joining the MSCI indexes should know what they are getting into by sending their money behind the yuan Great Wall: lax enforcement of standards for everything from insider trading to fraudulent financial statements, potential long-term trading suspensions, and limits on how much they can buy and sell.

Despite promising for decades to liberalize the yuan, there is no end in sight to Beijing's tight capital controls. China has become the market that no one really wants to be in but no one can afford not to be. Most investors have opted simply to accept the Faustian bargain and accept the risks that the company they have bought into may suspend trading of its shares without notice.

These are not everyday risks but they can be substantial. A company may not suspend its stock frequently, but a six-month trading halt can really hurt an asset manager. Similarly, if many foreign fund managers are trying to sell Chinese holdings at the same time, the quota on taking currency out of the country could easily get used up before some get their chance.

Like many companies and investors facing the conundrums of China, MSCI has opted to be a part of its markets regardless of the risks or the standards it had set for itself. The problems and frustrations of doing business in China usually grow over time but most opt to carry forward given sunk costs. MSCI investors know what they are getting into and the terms they have signed on to. The outcome now is upon their shoulders.

Christopher Balding is an associate professor of political economics at the HSBC Business School of Peking University in Shenzhen, China.

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