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China should seize on MSCI entry to overhaul its markets

Reform of IPO process and rules key to boosting foreign interest

| China
High-tech initial public offerings like that of Foxconn Industrial Internet and the addition of domestic stocks to MSCI's global index will bring more foreign investors into Chinese equities.   © Reuters

Chinese domestic stocks are set to go mainstream on June 1 for fund managers around the world. That is when 234 Chinese domestic stocks will join the MSCI Emerging Markets Index, coinciding with a push by Beijing to smooth the way for high-flying technology companies, which in the past have flocked to New York and Hong Kong, to list on the mainland's stock exchanges.

No fund manager has been able to avoid the China story as the country's rise has affected all areas of the global economy. But this first round of domestic Chinese stock additions to the MSCI will compel institutional investors controlling the estimated $1.7 trillion in funds that track the company's Emerging Markets Index -- or which are benchmarked against it -- to buy such shares for the first time. They will be pushed to buy more in September when MSCI raises the weighting of these shares in the index from 2.5% of their free float to 5%.

Meanwhile, China is also set in the coming days to see its biggest initial public offering in three years, as Foxconn Industrial Internet, a subsidiary of Taiwan's Hon Hai Precision Industry, raises $4.27 billion in Shanghai. While most companies applying to the authorities to list shares domestically have to wait years for approval, Foxconn got the go ahead in just five weeks.

The combined effects of MSCI inclusion and high-tech companies listing domestically could be profound in the longer term. But don't expect quick changes. There is still a huge amount of work to be done both in changing conservative mindsets in the bureaucracy and revising restrictive rules and regulations. Yet a brighter future can be imagined.

Increased foreign holdings via the announced MSCI changes will be relatively minimal and focused in the largest companies. Even after September's bump, domestic Chinese stocks will account for just 0.78% of the Emerging Markets Index. While inflows this year both in anticipation of MSCI inclusion and those expected to be made after June 1 to align with the benchmark are estimated to reach as high as $40 billion, this will not be enough to meaningfully raise the foreign ownership of domestic stocks from the current level of below 2%.

Shareholder activism will not suddenly spring from index inclusion. The inflows will be just too small for now to have an impact and there is little history of shareholder activism in China on which to build.

MSCI ranks index members by environmental, social and corporate governance criteria. By the compiler's standards, the Chinese companies to be added to its indices generally rank poorly but MSCI has organized workshops with them to explain ESG concepts and why they matter to a growing number of foreign investors. Some Chinese companies will no doubt grasp the value of ESG but others won't.

China's new willingness to revisit its listing rules is likely to be far more important. The rules have been seen by many entrepreneurs as too harsh in demanding that companies show at least three years of profitability.

One initiative in the works would allow Chinese companies now on overseas exchanges to list so-called China depository receipts on a domestic market. Officials from the China Securities Regulatory Commission have also suggested the three-year profit rule could soon be relaxed for technology companies but no concrete plans have been announced yet.

The CSRC has so far failed to move forward with long-discussed plans to shift from a system of approving each IPO to merely requiring companies to register to list. Although last year saw a record 438 domestic IPOs, which together raised 230 billion yuan ($36 billion), the authorities have kept a tight rein on listings in large part to ensure that only quality companies come to market. In addition, the practice of underpricing IPOs remains entrenched, as evidenced by the continued doubling of share prices in the first weeks after new stocks are listed.

The long waiting list has driven many entrepreneurs to look to Hong Kong, New York or other overseas markets to list instead. Yet the authorities' confidence in picking winners in new economy industries like artificial intelligence and biotechnology underpins the moves to loosen rules for high-tech "unicorns." By allowing some to list early, this can become a self-fulfilling approach as an IPO will allow the chosen companies to raise their profile and get an edge on their competition.

It isn't clear why an unprofitable tech company should be more worthy of a stock market listing than say an unprofitable property company. They may be better at presenting themselves as the companies of the future, but that does not make it so. The fraud scandal that swallowed up U.S. blood testing company Theranos should stand as a lesson for those who idolize innovative companies!

But combine a friendlier listing environment with the developing MSCI story. Whereas before many Chinese companies needed to go overseas to raise funds from the public markets, MSCI inclusion means that global investors will increasingly come to China. Not every new listing will meet MSCI's criteria, but it is certainly plausible to see how the calculus of listing will change, albeit in a small way.

China has failed to grow mature domestic markets in spite of thousands of listings and billions of dollars raised from IPOs. Part of that can be explained by the fact that the best and brightest companies chose or were forced by a restrictive local environment to list overseas.

The best thing China can do now is to proceed with reform of its listing rules and invite the world to invest in its best companies. MSCI inclusion will provide part of that invitation. The money will now come but will China make its best companies available?

Revised rules for the Qualified Foreign Institutional Investor program, still the primary channel for foreign funds to buy Chinese domestic stocks, are expected later this year. If the new rules really widen access substantially, this should almost automatically lead to a greater China weighting in the MSCI index, in turn bringing in more money to even more names on top of the initial 234 domestic stocks to be included this week.

The wait for MSCI inclusion has been a long and needlessly torturous one due to China's slowness in widening access to its domestic markets. Now that the moment has arrived at last, it would behoove the regulators to seize the opportunity this presents to overhaul markets. The world is keen and ready to take part once the Chinese embrace needed changes.

Fraser Howie is co-author of "Red Capitalism: The Fragile Financial Foundation of China's Extraordinary Rise." He has worked in China's capital markets since 1992.

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