For many investors, news that Morgan Stanley Capital International (MSCI) has decided to include Chinese stocks in one of its MSCI global equity indexes was about as exciting as the report that Peru’s exports of mandarin oranges have increased by 20% in the last five years (true story). Most investors prefer to keep their portfolios close to home, buying stocks only in companies of their own countries. Whether it’s due to patriotism or familiarity or just habit, it just feels right. Even when it’s wrong.
But if you’re one of the many U.S. growth investors who has considered buying stock in companies located elsewhere in the world, you’ll find this move interesting.
Chinese Stocks Now Welcome
What happened is that MSCI, after years of considering the inclusion of Chinese domestic A shares in its MSCI Emerging Markets index, finally took the plunge. Chinese stocks will be less than 1% of the index (0.7% to be exact), and only 222 stocks will be included. But it’s still a big deal.
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First, it’s important because for the past three years, MSCI had considered the move but decided not to. That’s because 1) the Chinese government allowed excessive interruptions in A shares trading when the market got too volatile and 2) the value of the Chinese currency was subject to too much government control.
Like all good capitalist institutions, MSCI insists that market forces be allowed to control market action—not government policies. The number of trading suspensions has declined over the past year or so and more Chinese stocks are now tradable through Hong Kong exchanges where transactions are in Hong Kong dollars. Both of these developments helped bring about MSCI’s move.
It’s also important that Blackrock, the biggest asset manager in the world, supported the inclusion of China when MSCI was doing its annual review of what should be included in the Emerging Markets index. Without a major ally like Blackrock, China would likely still be on the outside looking in.
Chinese stocks will be added to the index over the next two years, and additional stocks will be added to reflect China’s actual economic weight among emerging markets.
One important consequence of China’s acceptance into a major international index is that it advances the integration of China into the global economy, which is a big deal. China’s government has often exerted a degree of control over companies there that wouldn’t be allowed in free market economies. China has even resisted the requirement that independent auditing firms be given complete access to a client company’s books for financial reporting certification purposes.
China Becoming a Developed Market
For investors who have been using American Depositary Receipts (ADRs) as a way to gain exposure to Chinese companies, the MSCI move won’t change much. ADRs give access to the strength of Chinese companies without the complicating factor of currency fluctuations and add the assurance that Chinese ADRs have been through the vetting and certification process required to gain entry into major U.S. exchanges.
But as a step in the integration of the Chinese economy with the world economy, MSCI’s step is a big one. China’s economy is one of the world’s largest, and it’s only the excessive role played by the government that keeps it classified as an emerging rather than a developed market. South Korea and Israel are the latest countries to make the transition from emerging to developed status, and China will eventually join them. And that will be a good thing.
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