Beijing dealt a blow as major stock market index refuses to include China equities

SHANGHAI (Bloomberg) - China's domestic equities were denied entry into MSCI Inc.'s benchmark indexes for a third time, a setback for President Xi Jinping's efforts to raise the profile of mainland markets and turn the yuan into an international currency.

The index compiler cited the need for additional improvements in the accessibility of the A-share market for the decision, according to a statement on Tuesday. MSCI, whose emerging-market index is tracked by investors with US$1.5 trillion in assets, said it will reconsider inclusion in its 2017 market classification review, while not ruling an earlier announcement.

China was rejected despite a flurry of measures this year to address MSCI's concerns, including curbs on arbitrary trading halts and looser restrictions on cross-border capital flows. The decision suggests international investors are still uncomfortable putting their money in the $6 trillion market after a botched government campaign to prop up share prices roiled global equities last year.

While Chinese authorities have demonstrated a commitment to opening the market, "investors clearly indicated that they would like to see further improvements in the accessibility," Remy Briand, MSCI's global head of research, said in the statement.

'Significant Hurdle' Investors need time to assess the effectiveness of recent policy changes on the quota allocation, capital mobility and trading suspension, the index provider said. MSCI also pointed out that the 20 percent monthly repatriation limit remains a "significant hurdle" for investors that may be faced with redemptions such as mutual funds. The local exchanges' pre- approval restrictions on introducing financial products also "remain unaddressed," it said.

"The MSCI decision signals that China remains a closed emerging economy that uses market techniques like freezing the market and making it illegal to short, using government funds to buy shares - techniques that are not welcome among global investors," Paul Christopher, head global market strategist at Wells Fargo Investment Institute, said by phone. "There are a number of market reforms in progress, but these are the decisions MSCI would want to wait for and examine." The Deutsche X-trackers Harvest CSI 300 China A-Shares ETF, the biggest U.S.-listed exchange-traded fund tracking mainland stocks, fell 2.3 percent at 6:01 p.m. in after-market trading in New York. The offshore yuan lost 0.2 percent.

Investor Concerns Among the 23 strategists surveyed by Bloomberg in May, 10 had predicted entry, while five forecast a rejection and eight said it was too close to call. The Shanghai Composite Index dropped 2.9 percent during the past two days, extending this year's slump to 20 percent, as traders braced for a potential exclusion.

Government intervention has also been a key concern for many money managers after officials responded to a US$5 trillion equity crash last year with a share-sale ban on major investors and a crackdown on trading of stock-index futures. While some of the measures have since been eased, futures volumes are still more than 90 percent below their level a year ago.

"I am not surprised," Michael Kass, a New York-based money manager at Baron Capital Inc., whose $1.9 billion emerging- markets fund has outperformed 99 percent of peers tracked by Bloomberg over the past five years, said by phone. "It would make more sense to spend time reviewing the events of the last 12 months in terms of government intervention in the A-share market. You don't see that happening in the main markets that are included in the indexes." Chinese authorities had pushed hard for the MSCI nod. In February, regulators allowed qualified traders to shift money in and out of the country on a daily basis, a key change for open- ended mutual funds and ETFs. In May, domestic stock exchanges published rules restricting trading halts. And this month, China gave a 250 billion yuan (US$38 billion) investment quota to the U.S., allowing American institutions to invest overseas yuan in mainland markets.

Despite MSCI's rejection, China's combination of size and improved access makes the market hard to ignore for many investors. Mainland-listed shares account for about 9 percent of the world's equity capitalization, data compiled by Bloomberg show, and the nation's economy has been by far the biggest contributor to global growth in recent years. The $36 billion Vanguard FTSE Emerging Markets ETF, which tracks indexes compiled by an MSCI competitor, already invests in domestic Chinese shares.

Deserves Entry Exchanges in Shanghai and Shenzhen give investors access to more than 2,900 companies, many of which are more geared to the nation's growing consumer sector than those with overseas listings in Hong Kong. So-called H shares have long been part of MSCI indexes, while U.S.-traded Chinese stocks were granted inclusion in November.

"China is the second largest economy in the world," said Kristian Heugh, whose Morgan Stanley Institutional Fund Global Opportunity Portfolio has returned an annualized 20 percent over the past three years to beat 99 percent of peers tracked by Bloomberg. "It really deserves to be in these global indexes, especially the emerging-market indexes," he said. "The capital markets are being opened up to foreign investors and there are quite a few high quality companies in China." Still, activity through the Shanghai-Hong Kong exchange link suggests demand from overseas investors has been tepid. Foreigners have used less than half of the quota for net purchases of mainland shares since the program began in 2014.

The market's extreme volatility over the past year has been a deterrent. After more than doubling in the 12 months through June 2015 as China's mom-and-pop investors piled into stocks with borrowed money, the Shanghai Composite has since tumbled more than 30 percent for the biggest slump among major world markets.