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Why MSCI decision on China shares can cause market dislocations

Why MSCI decision on China shares can cause market dislocations

An impending decision by global index provider MSCI on including China A shares in its world and emerging market indices could lead to liquidity issues in financial markets, according to Citywire A rated Jian Shi Cortesi, investment manager at GAM.

‘Increasing the allocation to Chinese equities in the MSCI World and Emerging Market indices could markedly boost flow levels for a number of reasons,’ Cortesi said in an investment update.

‘Most international investors are not currently buying Chinese A-Shares. Sourcing information is challenging for many investors due to the language barrier, and many are not prepared to buy A-Shares as China is not yet included in the index.

‘All China related ETFs will have to start buying these Chinese stocks when they are included in the benchmarks.’

Approximately 25% of the MSCI Emerging Markets Index is currently allocated to China, but with the addition of Chinese A-shares and US American Depositary Receipts (ADRs) – Chinese equities listed on the US exchanges – this could increase to more than 40% of the index, noted Cortesi.

A decision by the MSCI is expected on June 9.

In recent weeks, another index provider, FTSE Russell, announced that it would launch two transitional indexes that include China A-Shares.

In the case of the MSCI, Cortesi believes there could be a series of gradual weighting increases over a few years. 

She noted that currently China’s QFII schemes and Stock Connect programme have quotas and could digest only a certain amount of flows; liquidity problems could arise if all index providers announced an inclusion in short proximity, making the potential for market dislocation quite large.

“As all ETFs have to purchase the underlying shares on the same day that an index provider’s change to its allocation comes into effect, flows into US listed Chinese companies and Chinese A-shares could be very significant. 

‘US-listed ADRs from China will be added into the existing MSCI China Index, which currently tracks Hong Kong listed Chinese companies, after they have been evaluated during the Index Review in November 2015. This will result in significant inflows into ADRs, but outflows from current index constituents,’ she added.

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