China Stands Alone

When the MSCI first created the Emerging Markets index in 1988, China was not included as one of the original ten countries. At the time, China did not have a local stock market and generated 3% of global GDP. Today the story is rather different. At over US$14 trillion, China’s GDP is now the second largest in the world, behind the US, and the country is now the single largest constituent in the MSCI EM index at 35%. Moreover, this weighting will grow over time as mainland listed A shares are gradually added to the index. Once the A share inclusion is complete, China’s index weighting will rise to 42%. Given this outsized presence, it overshadows the other 25 countries. It is now time for China to be promoted to a standalone market. 

The drivers of Chinese returns within the MSCI EM index have been increasingly narrow. Over the past nine years Chinese stocks delivered a total return of 160%, with Alibaba and Tencent responsible for nearly half the return, while the EM index only returned half of that. Of the 80% return generated by the index, half came from China alone. However, since February of this year, this cycle of outperformance has been broken as a result of the Chinese government’s crackdown on the bellwether tech stocks, which started with the aborted IPO of Ant Financial late last year. As a result, many are now reconsidering their China exposure, given the capricious and sudden changes in the broad regulatory environment that govern all Chinese companies. Naturally these matters are not an explicit issue for a quantitative driven process such as index weightings, although performance clearly does drive participation after inclusion. 

There are also other matters to consider. In a world where ESG is becoming increasingly important, how should one score China? At the government level it would surely be a “fail” for multiple reasons. At the company level “G” is increasingly challenged by the increasing influence of CCP “observers”, whose influence on company strategy and policy is difficult to measure, let alone assess, in the context of minority shareholder rights. For whose benefit is the company being managed these days, shareholders or the CCP? These are fundamental issues that are increasingly difficult to ignore. 

Chinese companies listed in the US have lately become an issue as well, with the worsening of relations between the US and China. Starting with the Trump administration, and now with Gary Gensler helming the SEC, it has been made clear that unless Chinese companies 

comply with US audit requirements they will be delisted. Another critical risk is that the foreign listed Chinese companies have done so under a legal framework known as Variable Interest Entity (VIE). This structure was never explicitly blessed by the Chinese government and clearly leaves shareholders with questionable, quasi-legal ownership rights.  In a worst case scenario, a foreign investor could wake up one morning to discover that their share ownership has disappeared following a new policy or legal directive from the CCP.

Digging deeper, it should be noted that the MSCI EM index is already something of a misnomer, given the presence of Taiwan and South Korea, both of which emerged a long time ago, and their continued presence in the EM index serves interests that have nothing to do with consistency of terminology and categorization. Including China, all three countries now represent a dominant 63% of the index, which in turn hinders flows to smaller EM countries that sorely need Developmental capital.

Since the coining of the term “emerging markets” in 1981, there has not been a serious reconsideration of what emerging markets are post the coining of “BRICS” in 2001. As the MSCI EM index has now become increasingly lopsided, it is now time for MSCI to reexamine the broader rubric of emerging markets, and what this category really means for investors.  China’s outsized weight threatens to overwhelm and dominate the overall performance of the index, which eventually will render it useless as a vehicle for investors to get broad based exposure to a diversified set of rapidly growing countries across the world. Moreover, if the various risks of investing in China increase further, the implications could be even more serious. Investors should have the ability to decide their own allocation to China, separate from their desire to invest in the emerging markets asset class. Its time to promote China out of the MSCI EM index.

 Jonathan Binder is the CIO of Consilium Investment Management.