Banking & Finance, Talking Point

Taking stock

Will MSCI’s inclusion of A-shares be overshadowed by trade war tensions?


Looking for a bull market: MSCI inclusion would normally be a buy signal but this time the mood is cautious

If US President Donald Trump really wants a full-blown trade war with China, Wall Street investors are not yet feeling the pinch.

Take the Dow Jones Industrial Average. The index closed at a record high of 26,616 on January 26 this year and more recently it has been trading at about 5% off that peak.

China’s heavily regulated A-share market has been more jittery. Hovering at around the 3,100-point level for much of this year, the Shanghai Composite is effectively at half of its historical high of 6,124, which was reached on October 16, 2007.

Two opposite forces have been at play in the Chinese market. At one end, the fear of escalating trade conflicts between the world’s two biggest economies is keeping investors on the sidelines; on the other, China has been trying to position itself as the global champion battling protectionism, and taking steps to liberalise its financial markets so as to draw in foreign capital.

This week MSCI finally announced which Chinese A-share stocks would be included in its indices. Seen by many in Shanghai’s financial district as long overdue, how will this impact the tug of war in Chinese stock sentiment?

The China-US trade war bubbles away

After trading barbs and bluffs, the US government finally found an arrow that hit the Chinese Achilles heel when a seven-year ban was imposed on American chip sales to ZTE for evading US sanctions on Iran and North Korean.

Officially this is not related to the China-US trade dispute although the sanction almost immediately shuttered a major Chinese telecom firm – a significant economic event given ZTE employs more than 80,000 (see WiC406).

Yet last weekend President Donald Trump tweeted another breathtaking twist in the ZTE saga. “President Xi of China, and I, are working together to give massive Chinese phone company, ZTE, a way to get back into business, fast,” Trump tweeted Sunday. “Too many jobs in China lost. Commerce Department has been instructed to get it done!”

The softening of Trump’s previous hard line came just ahead of talks with Chinese officials in Washington this week (led by vice premier Liu He, see WiC400).

Citing people from both countries who were briefed on the negotiation, the Wall Street Journal reported on Tuesday that Beijing and Washington are closing in on a deal that would give ZTE a reprieve. In exchange, China is prepared to remove tariffs on billions of dollars of American agricultural products such as soya beans (significantly grown in states that voted for Trump in 2016, which are viewed as crucial by Republicans in November’s mid-term Congressional elections). On top of that Chinese regulators also promised to restart a review of a proposed takeover of NXP Semiconductor by American chip designer Qualcomm.

“A deal isn’t completed and could fall apart as discussions continue, particularly since the US side is sharply divided over how to deal with China,” the Journal reported.

Meanwhile, Hong Kong newspapers noted that Chinese Vice President Wang Qishan is not part of the visiting Chinese delegation to Washington. The absence of the top official charged with dealing with Washington, the newspaper said, is a sign that a truce is nowhere in sight.

“Beijing expects this to turn into a lengthy tussle with the Americans,” Hong Kong Economic Times wrote. “As a negotiation tactic there is no need for Wang to show up at too early a stage.”

Meanwhile, the South China Morning Post reported that Wang could indeed visit Washington in late June or July, in an attempt to pave the way for “strategic-level dialogues” between the two countries.

Beijing has an unexpected ally…

MSCI announced in June last year that it would include China’s A-shares in its widely tracked emerging market benchmark index (see WiC371).

The index compiler had been mocked in China as “Must Short-sell China Indefinitely”, for the many years of delay in making that landmark decision (see WiC329).

Now MSCI has been hailed by Chinese media as an unexpected ally that has vindicated Beijing’s efforts to open up its financial markets. Xinhua described the inclusion as “a milestone in the internationalisation of China’s capital markets” and added that it provided “new channels for global investors to share in the big cake of China’s strong growth”.

The A-share inclusion will take place on June 1. MSCI announced on Monday that 234 A-share firms (out of a 3,564 total) will be given a 0.39% aggregate weighting in the MSCI Emerging Markets Index, the benchmark tracked by most fund managers globally. The second phase will occur in September, and is likely to double the yuan-denominated stocks’ combined weighting to 0.78%. The eligible stocks are mainly large caps such as state-owned heavyweights ICBC, PetroChina and Kweichow Moutai but ironically ZTE is also on the list.

The MSCI announcement has put Chinese stocks in the spotlight. “China’s stock market is about to go global like never before,” was Bloomberg’s verdict.

“While some foreign investors are still haunted by memories of China’s 2015 stock market crash and concerns about Sino-US trade frictions, a deeper fear of missing out is widely expected to boost overseas investments in mainland stocks,” Reuters also suggested in a report this week.

“The moment to buy Chinese A-shares is almost at hand,” wrote Financial Times columnist John Authers on May 17.

Why China’s MSCI entry matters

MSCI’s indices are closely watched around the world. Its emerging markets index, for instance, has been tracked by funds controlling assets in excess of $1.6 trillion.

Foreign fund managers who follow the benchmark will now need to buy into the Chinese stock market or else deviate from the index. Chinese investment bank CICC calculates that because of this up to $10.2 billion of foreign capital will flow into A-shares in the short term.

This sounds minuscule but many analysts are more optimistic, with some suggesting that amount could rise to $300 billion as the weighting gradually rises in coming years.

Perhaps more significantly, it is also a symbolic win for China. MSCI has previously rejected, or delayed, China’s entry on concerns such as accounting principles and the restrictions on cross-border capital flows.

Now China can stake a claim that its capital markets are liberalised enough for global recognition, although some remain sceptical that Beijing will ever allow a truly free market.

Case in point: at a recent financial conference in Hong Kong, a poll asked when foreign participation in onshore Chinese markets will be as open as New York or Hong Kong. The Wall Street Journal noted that about half of the nearly 300 respondents said within 20 years, while 21% chose “never, who are you kidding?”

As matters stand, foreign investors can only buy Chinese stocks in a handful of programmes carefully designed to control risk. These include the so-called “Stock Connect” schemes linking Hong Kong’s stock exchange to the Shanghai and Shenzhen bourses. The daily quota for “northbound” purchases of shares has been quadrupled to Rmb52 billion ($8.16 billion) beginning this month. Besides this there are also the “qualified foreign institutional investor” (QFII) and RMB QFII (RQFII) schemes for institutions such as foreign sovereign wealth funds to directly invest in Chinese stocks and bonds with quotas allocated by Chinese regulators.

These privileged allocations have been used by Beijing to make new friends. And they could become the carrot to lure the Americans’ allies to the Chinese side. For example, the People’s Bank of China said last month it will create the London-Shanghai Stock Connect within this calendar year.

Is Beijing luring US allies?

Last week, Chinese Premier Li Keqiang also announced that his country will give Japan a Rmb200 billion quota – which is a first – to buy Chinese stocks via the RQFII programme. Besides that Li also proclaimed he holds “a positive attitude” towards setting up a renminbi clearing bank in Tokyo.

These giveaways happened during Li’s visit to Japan last week, the first visit by a Chinese prime minister since late 2011. China’s relation with Japan have soured in recent years owing to territorial disputes.

On top of giving Japanese investors bigger access to the A-share market, Li also revealed both countries had agreed to speed up talks on creating a free trade pact along with South Korea. Following a trilateral summit in Tokyo, Li has flaunted the idea of a new cooperation model which he cryptically referred to as “China-Japan-South Korea plus X”. The “X factor”, the Global Times believes, is North Korea after it gives up its nuclear programme (see WiC408).

This was a far cry from the situation in February this year, when Australian newspapers reported that Australia, the US, India and Japan are talking about establishing a joint regional infrastructure scheme to counter Xi Jinping’s Belt and Road Initiative.

Now it is suggested that the American allies might have second thoughts.

The latest unpredictable policy U-turn by Trump on ZTE, an Australian Financial Review op-ed suggested, is further proof that Australia should not “blindly follow Trump” and it proves yet again “Australia needs to chart its own course on national security issues and China policy more broadly”.

Li’s visit to Japan, Bloomberg also noted, came just a month after Xi Jinping’s unexpected rapprochement with Indian Prime Minister Narendra Modi. Bloomberg considered this yet another proof that China is countering Trump by “mending fences from Japan to India”.

The erratic behaviour of the American leader is prompting China and Japan to think more about 2025 than 1945, William Pesek, a columnist wrote on Forbes. “Even his most ardent supporters never thought one of the things Donald Trump might ‘make great again’ would be Japan-China relations,” he opined.

Are A-shares poised for a bull run?

A China-Japan-South Korea free trade pact would help China’s economy grow by an additional 2.9%, Securities Times cited a recent research paper by the Chinese Academy of Social Sciences as saying.

That said, the newspaper also pointed out this idea has been under discussion for more than 10 years and an imminent breakthrough remains very unlikely.

Citing data from domestic brokerages, Beijing News suggested foreign investors have already been raising their exposure to Chinese stocks via the Stock Connect schemes on expectations that China’s MSCI entry could boost its stock market.

Yet the prevailing mood among key opinion leaders (KOLs) in financial social media platforms is a cautious one, with many warning that any bull run could by killed immediately should the US initiate more damaging trade warfare with China.

The increasingly fickle geopolitical situation could also pose uncertainties. For instance, Kim Jong-un on Tuesday threatened to cancel a historical meeting with Donald Trump scheduled for next month.

The level of trust between Beijing and Japan can be equally fragile despite the grant of the Rmb200 billion in RQFII quota.

After former Premier Wen Jiabao visited Tokyo in late 2011, Japanese investors also got a financial sweetener: approval to buy Rmb65 billion in Chinese government bonds – at the time that was the biggest foreign investment permitted for yuan-denominated debt.

Less than half a year later, Sino-Japanese relations were in tatters as Tokyo decided to press ahead with what it called the “nationalisation” of the Senkaku Islands, which China claims as the Diaoyu Islands.

To use another Donald’s famed phrase (this time Rumsfeld), the “known unknowns” may hold back an A-share bull market, despite MSCI’s pivotal decision.

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