One of the largest providers of global stock indices has again boosted the weight of Chinese shares in its emerging-market benchmarks despite strong headwinds from US lawmakers who are urging limited investment exposure to China.
MSCI, the New York-based index provider, on Tuesday added 204 China A shares to bring the China country weight to 33.7 per cent, or a third, in the emerging market index, data from JP Morgan shows.
“The benchmark is being skewed with one country weighing an unprecedented one third,” said Steven Schoenfeld, chief investment officer of BlueStar Indexes. “Never before in history was there a single country that counts so high.”
The increase, the third and final planned step-up this year, will compel US pension funds, mutual funds and other institutional investors that track the benchmarks to add billions of dollars more to yuan-denominated shares of Chinese companies.
From the November increase alone, China A shares are expected to see US$7 billion in passive capital inflows, JP Morgan data shows.
Combined with inflows of US$4 billion and US$3.3 billion from previous rounds of increases in May and August, China A shares will see an additional US$14.3 billion this year as a result of the changes.
Schoenfeld pointed out that Chinese e-commerce giant Alibaba alone now takes up 4.7 per cent in the index.
“A single company weighs more than the entire weight of Indonesia and Malaysia combined,” he said, emphasising the concentration risks caused by the latest addition.
Alibaba owns the South China Morning Post.
Not only did MSCI make the changes despite fund managers’ concerns about overconcentration, the move also went against calls by US lawmakers to curtail US investment in Chinese companies; they argue that the capital helps support a regime that poses a threat to national security.
Their warnings come amid a broader push for the United States to decouple from China as the trade war between the two countries, which began last year, has extended to a race for technological dominance and in financial markets.
In response to Tuesday’s move by MSCI, US Senator Marco Rubio said: “I remain deeply concerned about the risk to US retail investors and pensioners who may be unwittingly investing in opaque Chinese firms engaged in human rights abuses and a wide range of military-related activities.”
“I will continue to work with my colleagues in a bipartisan fashion to address this issue,” he added.
In an attempt to contain US exposure to Chinese shares, Rubio, a Republican from Florida, and Senator Jeanne Shaheen, a Democrat from New Hampshire, led a group of lawmakers who this month introduced a bill to prevent the board that oversees the US federal pension fund from shifting the benchmark to the MSCI indices.
The senators pointed out that the US$600 billion in assets managed by the Federal Retirement Thrift Investment Board (FRTIB) would be exposed to China’s capital markets. That would allow the retirement savings of federal employees and members of the armed forces to fund companies involved in the Chinese government’s military activities, human rights abuses and industrial policy, they said.
The senators named a number of Chinese companies as questionable, including AviChina Industry & Technology, Hikvision and ZTE.
But the FRTIB objected to the proposal, saying that restrictions on investing in China-based companies would deprive its participants of a significant opportunity for retirement returns.
Addressing that point, Schoenfeld said: “The issue is people investing in the index thinking they are diversified, but they are not.”
An MSCI spokesman did not respond to a request seeking comment about the latest increase.
Also at issue is the extra risk US investors face because of China’s lack of transparency.
“US-listed Chinese companies present regulatory, oversight and enforcement challenges that undermine transparency and confidence in US markets,” the US-China Economic and Security Commission said this month in its 2019 annual report.
The report noted that the inclusion of US-listed Chinese companies by MSCI extended the issue beyond direct investors in Chinese shares, but also to passive investors, including US federal workers saving for retirement.
“Chinese financial regulators continue to prevent the Public Company Accounting Oversight Board from inspecting the audit work papers of companies with major operations in China, which could leave US investors exposed to fraudulent activities,” the report said.
In the latest round of MSCI changes, top Chinese additions include Beijing-based brokerage firm CSC Financial and the biotech firm Hansoh Pharmaceutical, based in Lianyungang, Jiangsu, which each have a market capitalisation of about US$150 billion.
In the long run, MSCI and other major index providers, such as FTSE, are likely to add more Chinese A shares if China keeps opening up its financial markets.
“We could see US$36.8 billion further passive inflows into China A shares in a scenario where MSCI increases its inclusion factor and China foreign investment limits. That could mean US$221 billion of foreign inflows for China A shares,” said Zhang He, an index research analyst at JP Morgan.
MSCI said on Tuesday that any further inclusion of China A shares would follow a “public consultation”.
The firm said it would like to see Chinese government reform the market further, including access for international investors to hedging and derivative instruments to mitigate risks.
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