Trader Talk

China stocks rally on hopes of inclusion in global indexes

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The Shanghai and Shenzhen stock exchanges both rallied more than 3 percent overnight. There was no economic news. Instead the rally appears to be tied to the very political battle over whether China's two mainland stock exchanges — the Shanghai and the Shenzhen — should be included in the world's biggest indexes.

MSCI, the world's largest indexer, will soon announce whether it will include China's two mainland stock exchanges — the Shanghai and the Shenzhen — in its global indexes, particularly the MSCI Emerging Markets Index, which is the index used for the MSCI Emerging Market ETF, the world's largest emerging market exchange traded fund.

Right now, only Hong-Kong listed stocks are included in the indexes, there are no stocks from mainland China.

This is an important decision. It would, for example, roughly double the weighting of China in the MSCI Emerging Market ETF.

In a market that is increasingly global, this sounds a bit crazy. How do you ignore $6 trillion in equity market cap represented by the Shanghai and Shenzhen exchanges?

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The problem is, a lot of fund managers do not believe mainland China is ready for prime time, and they are pushing back on MSCI to tell them to put off a decision.

Exhibit Number One: the endless trading halts. Recall last June, when the onshore China market rolled over, and something like 1,500 stocks halted trade for anywhere from a few weeks to a few months.

That's a big problem if you are a daily liquidity provider like an index fund or a mutual fund. If a stock is halted, you can't buy it but you also can't sell it. How do you meet a redemption?

To address this issue, the Shanghai and Shenzhen Stock Exchanges have now said they will dramatically limit the amount of time a stock can be halted. It's now down to three months maximum. If that still sounds like a ridiculously long time, it is, but at least it's a step in the right direction. Whether it will be enough to satisfy MSCI is not clear.

But there is already some pressure on MSCI. Vanguard had MSCI's biggest competitor, FTSE, create a customized benchmark — the FTSE Emerging Markets All Cap China A Transition Index — for its Emerging Market Stock Index ETF that includes onshore China. Right now, Vanguard is the only one who uses this index, but the pressure is nonetheless on to include onshore China.

An announcement is expected from MSCI by June 14. If the decision is a go, you can expect the process to start in either in December 2016 or June of next year.

By the way, MSCI has already included U.S.-listed Chinese stocks in their indexes. The first half of the inclusion was done on Dec. 1. The second phase is tomorrow.

This means we can expect some heavy volume today at the close in the 13 China stocks that list here that will be included in the MSCI indexes, including Alibaba, Baidu,Ctrip,, Qihoo.