The MSCI Decision: Is China ready for prime time?

On Tuesday at 5pm ET, MSCI, the largest indexing firm in the world, will announce whether they will include mainland China stocks in their global indices. Right now, only Hong Kong and China shares that are listed in overseas markets (like the U.S.) are included.

Inclusion of mainland China stocks would be an important development. China's mainland market is roughly $6 trillion — nearly a tenth of the world's stock market capitalization, which stands at roughly $69 trillion. China's authorities have made inclusion in global indices a major priority.

Call it the triumph of the indexers: The whole world is moving toward investing using indexes and ETFs — most of which are pegged to these indexes. More than $10 trillion in assets are pegged to MSCI's global indices. This includes passive investments like ETFs and active management.

Let's just take one index — the MSCI Emerging Markets Index. Last year, there was $1.6 trillion benchmarked to that index (active and passive). This includes the largest emerging markets ETF in the world, the iShares MSCI Emerging Markets ETF, with roughly $22 billion in assets under management.

Right now, China accounts for roughly 25 percent of the weighting in the MSCI Emerging Markets Index. South Korea is roughly 12 percent, Taiwan 11 percent, India 8 percent and the remainder (Brazil, South Africa, etc.) 44 percent.

But that weighting only includes Hong Kong and Chinese stocks that are listed in overseas markets like the U.S.

If the index included all of mainland China,the weighting of China would go from 25 percent to 40 percent. That is a huge difference.

What will MSCI do? Much of the debate in the last year has centered around whether mainland China is truly ready for prime time. MSCI passed on including the mainland shares last year. Chinese authorities have worked to address the specific concerns of MSCI, which is simply reflecting the concerns of the global investing community.

Among the major issues:

1. Too many trading halts. During China's stock market meltdown earlier this year, more than 1,400 stocks were halted for anywhere from a few days to a few months, many at the whim of the company's management. This caused havoc with foreign investors who had to deal with redemption requests. Chinese authorities have now set the maximum period for a stock halt at three months — still ridiculously long — but at least there's progress.
2. Beneficial ownership: Do foreign investors actually own the stocks?Chinese authorities have confirmed that foreign investors do own the stocks they buy, even if the stocks are held by a local asset manager. This was a critical clarification.
3. Can foreign investors get enough to invest (quotas), and can they get the money out when they want to? This is a critical question for mutual funds and ETFs, which have to deal with daily demands for investments and redemptions. Chinese authorities have clarified that they will be able to get adequate allocations of stock based on the size of their firm, and are now allowing daily repatriation of money.

Still, given the occasional authoritarian outbursts from Chinese officials, MSCI has clearly implied that even if they say yes, this will be a gradual process. Why? Because they want to maintain leverage with the authorities: Keep up the reforms, or we don't go all in.

This isn't a big departure from previous emerging market practice. MSCI did a similar "carrot and stick" routine with Taiwan and South Korea some twenty years ago. It makes sense.

Why would Chinese authorities put up with this? After all, they are notoriously prickly about outside interference in anything, but particularly about their capital markets.

They will put up with it because they have no choice. China desperately needs foreign investment. They need it because they need to:

1. broaden their investor base;
2. institutionalize the onshore market, which is very retail focused;
3. reduce market volatility, and
4. have more capital inflows to offset capital outflows from their citizens.

So, what's going to happen? With Chinese authorities working hard for inclusion, and pressure on MSCI to include the missing one-tenth of the world's market capitalization, I would expect MSCI to adopt the gradualist approach.

The index they will use, the MSCI China-A index, has 420 stocks with a free-float market cap of $800 billion. MSCI has already indicated that if they say yes, they will limit the initial inclusion of the China A-shares (as mainland shares are called) in the Emerging Markets Index to only 1.1 percent of the weight of the index and gradually increase the weighting over a period of several years.

But even that is a lot of money initially: With $1.5 trillion indexed to the Emerging Markets Index, for example, 1.1 percent of that would be roughly $16 billion in stock that outside investors would need to buy — likely within a few months.

Of that $1.5 trillion, roughly 20% is purely passive investing, so even that would require $3.2 billion in buying.

And that's only 1.1 percent. Remember, the mainland market will be about 15 percent of the Emerging Market Index with a full weighting.

How many years before full inclusion? That depends on how fast Chinese authorities continue to open up their markets.