Unintended Consequences: China's Inclusion in MSCI


China's A-Share market has now been included in the MSCI Emerging Market Index. What does this mean for the corporate governance in China? EconVue asked our experts in corporate governance in Asia, Marsha Vande Berg and Nicholas Benes. Marsha begins the discussion with a key insight: not only will inclusion allow foreigners participation in China's market, if will drive improvements in corporate governance that will benefit Chinese investors.


Panel Discussion

Marsha Vande Berg EXPERT

Investors wanting ready access to the world’s most dynamic economy had their lives made easier recently when the most influential indexer in emerging market equities decided to add a sliver-size weighting of Chinese stocks to its MSCI Emerging Market Index. But the benefits of improved access are likely to accrue more to the Chinese economy than to growth-seeking international investors.

That’s because the governance of Chinese traded securities is still largely in the hands of the government, which as controlling shareholder determines companies’ strategic directions, their access to credit and even the executives who occupy the corner office. Over time, the hope is that the greater the access and bigger the capital inflows, the more Chinese authorities will take steps to accelerate reforms in terms of listed companies as well as the institutions that govern the country’s capital market.

Mohammed El-Erian, the chief economic advisor for Alliance, the corporate parent of PIMCO, summed up that thought when he decried MSCI’s refusal a year ago to bring China’s A-shares into the influential index. El-Erian described the potential success of A-shares inclusion as “the World Trade Organizational effect” and for investors, the opportunity to have their investment boats rise on the Chinese economic tide.

Alas, given current governance structures and standards, the opportunity for influencing faster paced reforms is closer to a trickle than a tidal wave. That is, unless investors decide to exercise the one vote they have, namely to vote with their feet.

So maybe it’s not all bad that MSCI’s decision gives investors their longed-for access to China’s mainland bourses beyond that afforded to large institutional investors who are signed up for the Qualified Foreign Institutional Investor program with its quotas and other controls. After all the Chinese economy, the world’s second largest, is maintaining its growth objectives of 6.5 percent. Or is it?

There may be multiple ways to address that question, but two answers are: On the one hand, the happiest outcome is that investors will be making long-term capital commitments. The bet has to be on a ten-year or more investment for returns to make a significant difference. In the process, investment can also contribute to greater market stability which in turn helps both sides of the investment proposition.

On the other hand, investors should realize that they will be investing in an economy that is still largely government controlled – even though the private sector continues to make strides and Beijing has made meaningful and clear progress in reforming its financial and capital markets. Investment makes sense assuming the investor is mindful that casino-like characteristics still describe China’s two primary bourses, in Shanghai and Shenzhen.

Whether active or passive, it will remain imperative that investors keep their eye on the corporate governance ball.

That is a more difficult proposition in China, than in Japan, for example, where there is a greater degree of transparency in addition to positive outcomes of recent reforms which are contributing to a structural change in the shareholder dispersion of listed companies, greater attention to minority shareholder interests and a larger role for independent, non-executive directors who serve on public company boards.

“Better governance is now recognized as a core national policy” and is essential to Japan’s economic future, says Nicholas Benes, head of The Board Director Training Institute of Japan and an architect of the ongoing corporate governance reforms in Japan.

The importance of corporate governance reforms, meanwhile, is also being recognized in South Korea, where recently-elected President Moon Jae-in is vowing to curtail crony capitalism at the same time he is encouraging the influential National Pension Service to follow the suit of Japan’s GPIF and adopt a stewardship code that advocates on behalf of stronger corporate governance in the publicly listed companies in which it invests.

Similar sentiment is likely to be slower to catch on in China, if it catches on at all. Consider the possibility that the importance of the New York indexer’s decision is more a symbolic gesture than an indicator of future large investment flows into China’s market. Taking effect next spring, the opening up to China A-shares is estimated to result in $15 to $17 billion in new investment into an economy that is nearly $11 trillion. This is roughly the equivalent of one-third of California’s economy.

In the meantime, the key corporate decisions for those companies owned and/or controlled by government interests at both the central and local levels will be meted out via SASAC, the State Council entity which was formed in 2003 to oversee and manage government interests in Chinese businesses. By one estimate, a little more than two-thirds – or 69 percent – of the 222 shares to be included on the MSCI index are owned by the Chinese state.  

It is worth noting that the New York indexer actually held its fire on three prior occasions, declining after polling its members to include Chinese A-shares in its powerful emerging market index. This time, however, they bowed to competitive interests as well as the overwhelming evidence that China’s A-share market –now the second largest in capitalization size – is too big to overlook.

But instead of a weighting in proportion to the size of the market, MSCI wisely decided to advance a sliver-sized stake of 222 companies on its index which is tracked by investment funds managing $1.6 trillion in assets. Taken together, these 222 large cap companies will represent a tiny weighting of 0.73 percent and less than five percent of the index’s overall cap weighting.

In announcing its decision, MSCI said that it hopes new-found investors’ interest in China’s A-shares will encourage the government to accelerate reforms. Indeed, MSCI announced it will increase the size of its weighting only if there is in the future “greater alignment” with international standards for accessing the China market, a relaxation of daily limits, continued progress on trading suspensions as well as the proven resilience of the index’s investment vehicle, the Stock Connect program.

Clearly, the underlying message is that while the China market is now too big to ignore, foreign investors will – and should require greater progress on reforms that eventually can ensure a level playing field.

Karim Pakravan EXPERT

China is already represented in both the MSCI-ACWI and MSCI-EM. However, up to the end of June, the A-Shares (the trading of which is restricted to QFII's were excluded. MSCI agreed to add A-Shares to its indices (in a gradual fashion) only when China agreed to liberalize access to the A-Shares market by foreign investors. The initial batch of A-Shares included 222 companies, with initially only 5% of their market cap to be included (adding 1% to the weight of China in the aforementioned indices. The inclusion of the A-Shares has been accompanied by an improvement in corporate governance at the level of the financial markets, but there are no provisions for improved corporate governance at the level of the companies themselves. Including Chinese A-shares in the MSCI indices in itself will not make the companies more attractive to foreign investors. At most it will allow some degree of portfolio diversification. Moreover, many if the companies listed have government ownership, which creates more distortions. Corporate governance reform has to be organic and internally driven.

Nicholas Benes EXPERT

I think this is probably a step forward, at least in terms of encouraging China to improve more and hopefully inserting healthy “competition between markets” in to the Asian governance improvement equation. Japan, China, Hong Kong and Singapore all aspire to be “the” central financial center of Asia, but as yet it is not clear that any of them truly deserve to become such from the standpoint of corporate governance.

According to the bi-annual analysis done by CLSA and the Asian Corporate Governance Association on the quality of corporate governance in Asia, some Asian stock markets (especially Australia) do a fairly good job of constructing rules, laws, governance codes, regulations, accounting principles, and to a lesser extent, enforcing them. But with the exception of Australia, Asian markets consistently fall short in the area of “corporate governance culture” and governance “ecosystems” – which is to say, the sum total of other things that companies do that go beyond the boundaries of those laws and rules. This encompasses a very broad range of things: codes of conduct and ethics, director training, attention to IR and disclosure beyond the minimum requirements, integrated reports, frequent investor meetings, stewardship codes and fiduciary duty practices, high-standard “best practices”, self-imposed governance “guidelines”, industry-wide director associations (institutes of directors), and so forth.

In recent years Japan has woken up to the need for going beyond “hard law” and has put in place a stewardship code and a “comply-or-explain” corporate governance code (which I myself proposed to the government), and is now experiencing a mini-boom in the implementation of ESG-based investment, albeit at a rudimentary stage. But it still has a lot of catching up to do in with markets like Australia and the UK in terms of: (a) pension governance - e.g., just consider that only one nonfinancial corporate pension fund has signed the stewardship code; and there is nothing like ERISA in Japan that imposes meaningful liability risk to trustees; and b) a native, naturally occurring “ecosystem” of associations and groups that support good corporate governance via training and the exchange of effective practices and experiences.

The low quality of pension governance law and practice is strange in the sense that Japanese companies claim to care for their employees, yet as judged by their actions, they do not extend the same level of care to their employees’ retirement savings. Still, change is in the air. At this point, following a study group that was formed after I proposed regulatory changes, everyone is waiting for Panasonic or Toyota to sign the Stewardship Code; if one of them does, a small avalanche of signatories is expected. IF this occurs, there is much upside, and other Asian markets would do well to take note.

My own organization, The Board Director Training Institute of Japan, seeks to cultivate the corporate governance “ecosystem” in Japan, by focusing on director and pre-director training, analyses of governance practices and their efficacy, and information dissemination. While we have made great progress in growing the concept of director training from a seed to a seedling, what is needed most in Japan is much more active support of such activities by domestic institutional investors, who tend to be so conservative and afraid of new trends that they conveniently choose to do nothing at all to improve their own market. Therefore, points (a) and (b) above are directly related. Better pension governance and stewardship by the most important asset owners, pension funds, would filter down through the investment chain and move Japan towards a virtuous circle by addressing ecosystem gaps.

Marsha Vande Berg EXPERT

It doesn’t matter if the corporate governance is black or white, when it concerns Chinese companies – stated owned or privately-held -- investors’ due diligence is the only game worth playing.

Like listed companies worldwide, Chinese companies reflect the market economy in which they operate. In China’s case, it’s a social market economy that is subject to market forces, engages capitalists but run with the Chinese Communist Party’s interests paramount. The government’s hand can be heavy, non-transparent and a key influencer in the interplay between China’s brand of capitalism and governance matters like minority shareholder rights.

When it comes to shareholder protections, China’s corporate governance standards acknowledge the validity of such concerns, and the country’s legal system is supposed to guard them in principle. But at the end of the day, the trade-off becomes the reconciliation of twin goals of maximizing shareholder value and advancing the economic interests of the state. 

What this means for investors who want to buy into the China miracle growth story is not to avoid Chinese companies but exercise appropriate due diligence into their governance structures and a company’s relationships with government before signing off on the investment.  China’s economy has made phenomenal strides, but it is still run more like a planned economy than not, and the government is still planner-in-chief. 

Consider possible implications for China’s e-commerce star, Alibaba, which listed in 2014 on the NYSE, of the four sprawling Chinese conglomerates now in the government’s cross hairs for building global empires and using state-bank debt and their key connections.  One of the three is traded – Fosun International on the Hong Kong exchange, but all four – like Alibaba – depend on the Chinese marketplace and their relationship with government.

China’s Communist Party’s newspaper describes companies like the four conglomerates as “gray rhinos” because they pose problems for the economy which go ignored until the start moving fast. Each of the four – Anbang Insurance, which is now under orders to sell the famed Waldorf Astoria which it bought for $2 billion during its acquisition spree, HNA Group, Dalian Wanda Group, a real estate consortium, and Fosun International, a financial and industrial operation, which is traded in Hong Kong – ramped up growth by acquisition using state bank loans and at the government’s urging to build China’s global presence. Their combined spending on acquisitions abroad was an estimated $41 billion at a minimum. 

But when the tide on Chinese debt began receding, the gray rhinos were exposed as part of the problem. The OECD reported recently that China’s debt levels internally had exceeded GDP by 250 percent, and of that, 170 percent was corporate debt. The Party’s bigger concern arguably was the potential for embarrassment during the upcoming Party congress, meeting in late fall to decide the future political leadership for the next five and possibly ten years.

Technology companies have been luckier.  They are considered part of the solution and central to China’s declared intentions to transition its behemoth economy from its productivity-challenged manufacturing base to one where technology-driven innovation is the centerpiece. Alibaba is one such technology company. 

Alibaba, which first tried listing in Hong Kong but was turned down but then succeeded with the NYSE, has a governance structure that in no small way reflects multiple western corporate governance constructs but with a unique twist. The holding company, Alibaba Group Holding, has a board of directors; the company reports transparently to the SEC quarterly; it reports earnings and will report the new fiscal year’s first quarter earnings in mid-August. But 90 percent or more of its business is in China, where Alibaba relies on its access to the internet which government controls and regulates.

The holding company is managed by the Alibaba Partnership, which was designed specifically to keep founder Jack Ma and his managers in control of the company and its strategic direction. It’s similar to having a dual class stock structure, like Google and Facebook, and which recently was dealt a blow when the S&P 500 ruled out the future inclusion of dual class shareholding companies on what is the world’s most widely followed market benchmark. The decision also affects two S&P sister composites.

At the time, Ma held 8.9 percent and the Partnership owned 89 percent – sufficient for virtually lock-tight control on the company’s direction.

Headquartered in Hangzhou, the company operates online and mobile marketplaces in retail and wholesale trade, as well as cloud computing and other technology and related services cod consumers, merchants and participants generally in its online ecosystem. It operates Taobao Marketplace, an online shopping destination; Tmall, a third-party platform for brands and retailers; Juhuasuan, a group-buying marketplace; Alibaba.com, an online business to business marketplace; 1668.com, an online wholesale marketplace; and AliExpress, a consumer marketplace.

Alipay, China’s largest Internet payment service, started by Alibaba Group and later spun off into an entity that evolved into Ma’s Ant Financial Services Group, which provides a bevy of financial services in including Alipay and Yu’E Bao, now the world’s largest money market fund.  Alipay, together with China’s other e-commerce behemoth, TenCent Holdings and its WeChat Pay, dominate 90-percent share of China’s mobile payment market.

This month, Alibaba stock is forecast to notch another 90-cents per share when it reports quarterly earnings come mid-August. With lead revenue streams still dependent on commissions and advertising, Alibaba has been engaging in dual strategies of broadening its international holdings and therefore its latitude for operations while retaining bread and butter linkages with its bread and butter client, the Chinese consumer.

Via Ant Financial, Ma is expanding into the United States, with the acquisition of First Data Corp, a payments processor and Dallas-based Moneygram International, pending regulatory approvals. Via Ant Financial and other affiliates, his buying spree reaches into Thailand and India among others. Having chalked up ten acquisitions between September 2013 and March 2017, Alibaba Pictures, a movie and TV content business controlled by Alibaba, bought Chennai-based TicketNew, making Alibaba the largest B2B operator in the world’s second largest population center.

Its corporate debt is three percent on an enterprise value of $390 billion, compared to the much larger Amazon with an enterprise value of $480 billion and six percent debt.

Duncan Clark, author of Alibaba: The House that Jack Ma Built, describes the relationship between Ma and the Chinese government as an interesting dance. The government recognizes the utility of people like Ma and its leverage is it regulates Alibaba’s lifeblood.
Meanwhile Alibaba fulfils the Chinese dream of economic expansion via the technology sector. It’s likewise an interesting dance between Beijing and all of China Inc., and understanding that tune can be devilishly difficult. The government does not disclose who controls what, and it can’t be inferred. Alibaba’s exception is transparency by force of the governance controls under its NYSE listing.