G+Ms Milner: MSCI did well to stay out of manic Chinese market
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G+Ms Milner: MSCI did well to stay out of manic Chinese market

Finance

The Chinese stock market is in the grip of a full-fledged mania, with valuations incongruously soaring at a time when the economy is slowing and corporate profits are shrinking. Yet billions of dollars in additional foreign capital would be flooding into mainland Chinese equities if global index provider MSCI Inc. had added them to its benchmark emerging markets index.

When MSCI decided last week that China’s A shares – domestic equities denominated in yuan – aren’t yet ready to play on the world stage, there ought to have been sighs of relief from money managers everywhere. MSCI itself estimates their eventual inclusion could pump another $400-billion (U.S.) into Chinese equities.

“A lot of people dodged a bullet, in the sense that they’re not encouraged or forced to allocate into China at a time when it’s not very wise,” said Patrick Chovanec, chief strategist at Silvercrest Asset Management Group in New York and a former associate professor at Tsinghua University in Beijing. “If it turns into a repeat of 2007 when the market fell by 70 per cent, I don’t think there would be a lot of people thanking MSCI.”

Chinese authorities have welcomed the stock market boom, making it easy for small investors to rack up margin debt and using the tame media to explain why sky-high valuations make sense, even when they clearly don’t.

Why the official Communist fervour for this most capitalist of asset classes? Floating equity in a hot market is a low-cost way for property, financial and other profit-challenged companies to reduce massive debts and refinance operations. Initial public offerings have shattered records. And investor demand is so strong that some Chinese companies are delisting in the U.S., where they can’t get on investors’ radar, and floating new issues in their home market.

But the Chinese have reached the point “where they have basically fed the dragon, and now it may be out of their control,” said Ruchir Sharma, head of emerging markets and global macro at Morgan Stanley Investment Management in New York.

One measure of this is the huge volume of margin lending to buy shares. On an adjusted basis, margin debt now exceeds 8 per cent of the Chinese market cap. That compares with a U.S. level of 2.5 per cent, which, incidentally, is about the size it reached at the peak of the Internet bubble in 2000.

“Some of the statistics are absolutely crazy,” Mr. Sharma said in an interview from Athens. “All the sociological signs of a complete mania are there. The daily trading volume [on China’s two main exchanges] exceeds the rest of the world combined on some days.”

Another sign of deep bubble trouble: “When you have four million retail investors who are opening accounts every week,” Mr. Sharma said in an interview from Athens. “And I’m told something like a third of them don’t even have a high school diploma.”

MSCI, which isn’t concerned with extended valuations or other market excesses, couched its index decision in the most diplomatic of language. The index provider noted that “although institutional investors are eager to invest in China, a few more improvements must be made before they will consider the market to be sufficiently accessible.”

It laid out a clear blueprint of what Chinese authorities must do to gain admission – from full currency convertibility and greater transparency to the removal of impediments to moving freely in and out of positions. And it provided a timeline, noting that it will review the country’s status again by 2017.

Adding yuan-denominated equities to the index is “a very weighty decision,” said David Riedel, an emerging markets veteran who was part of an industry group that last year considered whether to downgrade Argentina and upgrade China.

“They have one chance to use this as a stick to encourage reform,” said Mr. Riedel, president of Riedel Research Group, which delves deeply into Chinese and other emerging market equities.

China tub-thumpers have taken MSCI’s measured approach as a signal that the biggest emerging market of them all will finally be included in the widely tracked global index. But Chinese stocks listed in Hong Kong already account for a whopping 25.3 per cent of the index. South Korea ranks second with 14.6 per cent.

When MSCI was debating the merits of including China’s A shares in its benchmark index, Mr. Chovanec commented that this “would be the best argument against passive investing that I could think of.”

In the end, the index provider put the issue on the back burner. But the current manic state of the Chinese market still makes a good argument for exercising independent judgment.

 

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