Expectations are high for Chinese A-shares to finally gain entry into one of the industry's respected equity indices this year. Critics are asking for the enthusiasm to be curbed.
MSCI is due to announce whether Shanghai and Shenzhen-listed stocks, or A-shares, will be added to its Emerging Markets Index on Wednesday, a decision that could see billions in foreign inflows flow to the world's second largest equity market. It comes one year after the U.S. analytics firm told Beijing further liberalization was needed before acceptance, pointing to factors such as the country's investment quota system that doesn't provide equal access to all money managers.
Despite ongoing volatility, characterized by wild swings in the renminbi, suspected intervention by state-backed funds and fears about economic growth, top officials believe MSCI will give the green light.
Over the weekend, Xavier Rolet, chief executive of the London Stock Exchange, called for the move, saying it would be critical for global investors, echoing similar comments by Qi Bin, head of the international cooperation department at the China Securities Regulatory Commission, who said a global index was incomplete without Chinese stocks.
But there is a key reason why MSCI may stand pat, according to to Richard Martin, executive vice president at IMA Asia: bad debt piled up by China's companies.
Officially, non-performing loans and special-mention loans are tracking around 5 percent of total lending but according to calculations by the International Monetary Fund (IMF) in April, that number is actually 14 percent, Martin said.
"That is a lot of bad debt washing around inside listed Chinese corporates. So would you want to buy into that? I'm not sure."
With corporate debt at approximately 145 percent of gross domestic product, Beijing needs to urgently commit to serious reforms to tackle the issue, IMF deputy managing director David Lipton noted over the weekend. Speaking at a conference in Shenzhen, Lipton warned corporate debt issues could easily escalate into systemic debt problems, risking lower economic growth and sparking a banking crisis.
Moreover, a lack of hedging instruments in equities and foreign exchange as well as concerns about heavy government intervention remain major hurdles for investing in A-shares, said Aidan Yao, senior emerging Asia economist at AXA Investment Managers in a recent note.
While these factors are not necessarily binding for MSCI, Yao believes "they could influence the decision to the extent that the inclusion may undermine the popularity of MSCI as a benchmark, given the prevailing bearish sentiment towards A-shares."
He doesn't believe MSCI will offer approval this time, predicting it will instead ask Beijing to address its full list of concerns, which includes anti-competitive clauses and capital mobility restrictions.
Indeed, full inclusion is almost "impossible" at the moment, agreed Bernard Aw, market strategist IG.
"Since the rejection from the 2015 review, China has addressed two out of the three key concerns, the share suspension mechanism and beneficial ownership, but accessibility is still a problem."