Chinese domestic equities are best avoided, and the reasons go beyond those cited by MSCI in delaying their inclusion in benchmark indices.
MSCI this week for the third time declined to incorporate shares traded domestically in China into its benchmarks, praising authorities for making progress in addressing its concerns but calling for further improvements.
MSCI cited, among other things, impediments investors face in getting their money out of China. They also called for more clarity and limits on the seemingly random way in which shares in companies are suspended from trading, often for long periods, leaving investors holding illiquid securities of highly uncertain value.
MSCI made the right decision in waiting for deeper reform by China, but even if that is forthcoming investors would be smart to wait further in order to give China time to establish a track record as a fair and reliable steward of investor rights in its capital markets.
On the face of it, it may seem strange that China is excluded from MSCI’s Emerging Markets Index or that an investor who wants global exposure might eschew it entirely. This is, after all, the world’s second-largest economy and one which represents about 9% of global market capitalization. If you are not exposed to China, you are making a big bet, right?
A big bet, but very likely a wise and principled one. It is hard to have confidence that you will be well treated as an investor in China, recent events being what they were. It is also very hard to calculate the risks of further mistreatment. It isn’t simply a matter of China changing the rules.
None of these have anything to do with taking a view on China as an investment per se. While you might have views one way or the other about the price of Chinese shares or the future path of China’s economy, my primary concern goes beyond that. It is this – I worry that investors in China won’t be given a fair shake and that they will be subject to capricious, arbitrary and unpredictable changes in government policy.
The actions taken by China in its stock market over the past two years were exactly that: capricious, arbitrary and unpredictable. Even if China changes policies and pledges good faith, it will be a long time before you can plausibly trust that these changes won’t be undone if it becomes expedient.
The mess last time
So let’s have a look at what happened in China’s stock market these past two years and the role played by state officials. First a bubble blew up in some parts of China’s stock markets, fuelled in substantial part by unsophisticated investors using borrowed money. While it is impossible to prove, part of the very reason investors were so enthusiastic was that many believed that the government was sponsoring the rise in the stock market as a means to cushion a transition away from an export-led economy to one with more domestic consumption.
Panic buying turned, as it so often does, into panic selling a year ago and the government, spooked that this was undermining its credibility with the nation, came down hard on those people and tactics it saw as responsible.
China waged a kind of campaign against falling stock market prices, or more accurately, against price discovery as a concept. Limits were placed on share sales by institutional and inside investors, a ban on short selling instituted along with a crackdown on futures trading. Trading in futures onshore in China is still only about a tenth of what it was before the interventions. More than half of all publicly traded firms suspended trading in their shares at one time or other, not to mention halts of the entire market called by regulators as “circuit breakers”.
There was also the chilling phenomenon of the way in which Chinese authorities went after those it thought were feeding the selling, with people going missing only to later be shown before camera “confessing” their crimes.
What is clear is that China views its capital markets as an instrument to be actively managed to achieve the aims of the state. That China has been less than adroit in how it approaches this is one problem. Its seeming willingness to trample rights in the process is a larger one, and an important warning sign investors should heed.
Not because China behaved badly, though it did, but because that bad behaviour as a regulator represents a risk and a signal of more risk in the future.
Investors may need a long time to get comfortable with those risks, and China a longer track record of better behaviour to live them down.
(James Saft is a Reuters columnist. The opinions expressed are his own. At the time of publication he did not own any direct investments in securities mentioned in this article. He may be an owner indirectly as an investor in a fund. You can email him at jamessaft@jamessaft.com)
