There is growing inclusion of domestic Chinese stocks and bonds in global investment indices. Increased index weight on Chinese markets has resulted in more passive exposure for U.S. institutions, mom-and-pop investors, and pension funds. These foreign markets are not subject to the scrutiny of U.S. regulators.
This article gives background on the increasing power of index funds to shape markets, describes the gradual opening up of China’s domestic stock and bond markets to outside investors, and outlines how the increased inclusion of Chinese assets in index funds has exposed passive investors to risks and downsides that they may not be aware of.
Index Funds, Index Providers, and Increasingly Passive Markets
A stock index is a weighted average of stock shares of publicly listed companies; bond indices are similar, representing baskets of market prices associated with selected bonds. Historically, stock and bond indices served primarily informational purposes. Indices such as the Dow Jones industrial average and the famous S&P 500 were printed in newspapers to help investors gauge the overall health of the market. Since the 2007-2008 financial crisis, however, there has been an increasing amount of money invested in “passive funds”, which mimic the portfolios prescribed by major indices. This contrasts with the traditional form of asset management, “active investment”, wherein highly paid managers pick stocks with the aim of ‘beating’ the market.
Between 2007 and 2021, the total assets under management (AUM) in exchange-traded funds (ETFs), the main kind of passive funds, jumped from less than $1 trillion {1} to more than $7.7 trillion AUM. {2} This shift from active towards passive investment came after actively managed funds had been unable to outperform market indices during the financial crisis.
As such, more and more investor money is riding on the performance of stock and bond market indices. The firms that design and calculate these indices, known as index providers, are increasingly powerful in determining how investors’ assets are allocated. Given that passive funds simply replicate indices, an index provider’s decisions to change an index compositions amounts to quasi-automatic reallocations for all assets invested in passive funds that track the index. In the past, these index providers only reported on the markets; now, increasingly, their decisions have the power to move and even create markets.
A salient example is the construction of “emerging markets” indices, which aggregate the stock and bond markets of various developing countries. When index providers choose to include or upweight the Chinese markets in their calculation of these indices, millions of American investors are given increased financial exposure to Chinese stocks and bonds, and billions of U.S. dollars are steered into those markets.
China’s Opening of Domestic Financial Markets to American Investors
The opening of Chinese financial markets to foreign investors has brought Beijing a multitude of benefits. Sophisticated international investors have bolstered China’s financial sector, and passive investment has helped to stabilize China’s economy. Moreover, state programs such as the “Going Global Strategy” and “Made in China 2025” have benefited from an influx of funding.
Before 2003, foreign investors were not allowed to directly trade in Chinese A shares, which represent 70% of the total value of the Chinese stock market. A shares, listed on the Shanghai or Shenzhen stock exchanges, are traded in Chinese yuan. This is in contrast to Chinese B shares and H shares, the other two types of shares that Chinese companies can issue, which are traded either U.S. dollars or Hong Kong dollars.
Access to Chinese A shares had historically been limited to mainland Chinese investors; U.S. investors were only allowed to trade in B Shares and H Shares. Beijing began to lighten restrictions on foreign investment in 2003, when a small set of carefully selected foreign institutions were allowed access to investment in A shares. This was followed in 2014 by the introduction of the “Stock Connect” market access program, which greatly expanded international access to China’s markets. This program allowed foreigners to trade in A shares via the Hong Kong stock exchange. Similarly, the “Bond Connect” program, introduced in 2017, gave foreigners access to China’s domestic bond markets.
Although international investors are now allowed some access to Chinese markets, the Chinese government tightly controls the flow of foreign capital. This is achieved via daily trading quotes and restrictions such as a 30% limit on the percentage of each Chinese company’s outstanding shares that may be foreign-owned.
Investment coming through the Stock and Bond Connect programs consists mostly of passive funds. Since holders of passive funds are typically seeking long-term gains and do not move their money in and out of markets rapidly, passive investment is stabilizing in nature. As such, the foreign, passive investment in China has countered the volatility resulting from speculation by the Chinese retail investors who dominate the markets.
International funding has helped finance Beijing’s strategic programs, such as the ‘Going Global Strategy’ and ‘Made in China 2025’. The Going Global Strategy, which encourages Chinese companies to invest capital in foreign countries, took off after the global financial crisis as China increased overseas acquisitions, especially in Europe and the US. The ‘Made in China 2025’ program, announced in 2015, is an industrial policy that aims to move China’s economy towards the upper end of the value chain, increasing the emphasis on high-value and tech-intensive manufacturing. These programs rely on massive financing through capital markets.
Moreover, global institutional investors have helped build up China’s financial sector and fulfill Beijing’s ambition of becoming a global financial powerhouse. Lacking the know-how to independently implement a “Chinese Wall Street”, Beijing has welcomed the transfer of expertise from global financial institutions.
Despite these benefits, Beijing has been wary of foreign speculators’ potential to disrupt Chinese markets, drawing lessons from the 1997 Asian Financial Crisis, as well as from the asset bubble and subsequent economic stagnation brought about by Japan’s financial liberalization in the late 1980’s.
Scale and Prospects of Indices Tracking Chinese Markets
As Chinese domestic markets become more accessible to international investors, major global index providers have increased the weight of Chinese markets in some of their indices. This has resulted in passive investors being increasingly exposed. The International Monetary Fund estimates that by mid-2022 the inclusion of Chinese domestic securities into major global indexes will drive up to $450 billion net inflow of passively invested funds into the Chinese economy. {3} This amounts to 3 to 4 percent of China’s GDP.
As background, the three top stock index providers are MSCI, FTSE, and S&P DJI {4}, and the three top bond index providers are Bloomberg Barclays, J.P. Morgan, and FTSE. In June 2017, MSCI decided to include Chinese A shares in its Emerging Markets index; FTSE Russell and S&P DJI followed in 2018. In May 2019, 5% of all A share stocks listed on the Shanghai and Shenzhen exchanges were included in the MSCI Emerging Markets index; by November, that figure increased to cover 20% of all eligible A share stocks. As a result of this increase in coverage, the weight of A shares in MSCI’s overall index rose to 4%, and the overall index weight on China rose from 28% to about 33%. FTSE and S&P DJI quickly followed suit, increasing their coverage of the A shares market to 25%. (See Table 1)
| Table 1: Major Stock Index Providers’ Weights on Chinese A Shares {5} | ||||||
| Index | Inclusion Process | Change in Coverage of A Shares | New Index Weight on A Shares | |||
| MSCI Emerging Market | May 2019 – Nov 2019 | From 5% to 20% | 4.0% | |||
| FTSE Emerging Index | Jun 2019 – Jun 2020 | From 0 to 25% | 5.4% | |||
| S&P Emerging BMI | Sep 2019 | From 0 to 25% | 5.5% | |||
Chinese government and bank bonds, too, are now more easily accessible to foreign investors. According to an announcement by FTSE Russell in 2021, inclusion in major indices will lead to expected flows of $130 billion into Chinese government bonds. (See Table 2)
| Table 2: Major Bond Index Providers’ Weights on China’s Domestic Bonds {6} | ||||||
| Index | Inclusion Process | Securities Type | Index Weight on
Domestic Bonds |
|||
| Bloomberg Barclays Global Aggregate Index | Apr 2019 – Nov 2020 | 386 Chinese government & policy bank bonds | From 0 to 5.5% | |||
| JPM GBI-EM Global Diversified | Feb 2020 – Nov 2020 | 9 Chinese sovereign bonds | From 0 to 10% | |||
| FTSE Government Bond Index (WGBI) | Oct 2021 – Oct 2024 | Chinese government bonds | From 0 to 5.25% | |||
How much U.S.-based money is in Chinese domestic markets? A U.S. Securities and Exchange Commission study of mutual funds estimated that, at the end of 2020, there was $38.9 billion of investment in A Shares and $15.8 billion of exposure to domestic Chinese bonds via top index providers. {7} But that only covers mutual funds, and does not account for public and private pension funds, endowments, foundations, and hedge funds.
Out of the ten largest public U.S. pensions at the state level, nine have allocated funds to track one or more benchmark indices that have exposure to Chinese A Shares. (See Table 3)
| Table 3: Large U.S. Public Pension Funds with Exposure to Chinese A Shares {8} |
| California Public Employees’ Retirement Fund California State Teachers’ Retirement System New York State and Local Retirement System State Board of Administration of Florida Teachers Retirement System of Texas New York State Teachers’ Retirement System Washington State Investment Board North Carolina State Ohio Public Employees Retirement System |
Passive Investment in Chinese Stocks and Bonds: Risks to Investors
The Chinese Communist Party (CCP) is using funds raised in the financial markets to further its domestic and global agendas. This means the perpetration of human rights abuses {9} {10}, information censorship {11}, espionage and technology theft {12}, and modernization of the Chinese military{13}. As such, this fundraising activity poses a threat to U.S. national security interests.
Most issuers of Chinese A shares are Chinese state-owned enterprises, many of which are in the high-tech and defense industries. Issuers of Chinese bonds covered by major indices include central and local governments as well as Chinese state banks. Although the SEC has taken steps to regulate Chinese companies listed on U.S.-based exchanges, firms that operate on Chinese exchanges are out of reach for American regulators. The same is true of Chinese banks and government entities.
This is especially problematic given the track record of fraudulent activity by large Chinese companies. For example, Kangmei Pharmaceutical, a company included in the MSCI Emerging Markets index, was found in 2019 to have “engaged in one of China’s largest financial frauds totaling US$12.6 billion.” Despite having engaged in “premeditated and malicious cheating of investors” through gross inflation of its revenue, operating profit and cash positions, the company was only made to pay a small fee, and it was not delisted from Chinese exchanges. {14}
Chinese entities can have their cake and eat it too; they get a regulatory free pass, being subject to zero audit and disclosure requirements, while still receiving billions of American dollars in investment via passive funds tracking emerging markets indices. Meanwhile, international investors are left holding the bag without a safety net.
In addition to the issue of fraud, international investors are subject to the market volatility brought about by the Chinese government’s policies. This has been the subject of several recent news cycles:
• In November 2020, Ant Group’s planned initial public offering (IPO) was abruptly canceled. {15}
• In April 2021 Beijing brought a series of antitrust actions targeting various tech firms, including a $2.8 billion fine for Alibaba. {16}
• Starting in July of 2021, Beijing went after the booming industry of education-technology and tutoring. Private companies were forced to become non-profit entities, banned from raising foreign capital, and forbidden from participating in acquisitions. Moreover, a slew of new regulations was passed constraining what subject matter these education companies are allowed to teach, as well as on what days and to which age groups it may be taught. {17}
• Also in July of 2021, the Chinese authorities launched a data security investigation into ride-hailing giant Didi Chuxing, erasing billions of U.S. dollars from its market capitalization within days of the company’s IPO on the New York Stock Exchange (NYSE). {18} This was followed in December of 2021 by DiDi Chuxing’s announcement that it would delist from the NYSE, less than six months after its IPO.
These grandiose moves have hammered China’s stock market, and international investors were along for the ride.
U.S. regulatory bodies have done little to protect American investment in Chinese stocks and bonds. Millions of mom-and-pop investors entrust their money to large firms such as BlackRock, Vanguard and State Street; most have no idea that, by purchasing passive index funds, their money is benefiting the Chinese Communist regime. In a letter to MSCI in June 2019, Sen. Marco Rubio said it well: “Firms like MSCI have an obligation to make sure investors know whether their investment dollars are unwittingly aiding Chinese state-owned and state-directed companies linked to China’s efforts to steal American innovation, undermine fair competition, increase threats to U.S. national security and economic security, and support China’s systemic and egregious human rights abuses.” {19}
Endnotes:
{1} Jan Fichtner, Eelke Heemskerk and Johannes Petry. (2020, January 8) Index funds might sound boring. But who decides which countries and companies to include? Washing Post.
https://www.washingtonpost.com/politics/2020/01/08/index-funds-might-sound-boring-who-decides-which-countries-companies-include/
{2} Statistia.com. (2021, February 19) ETFs – statistics & facts
https://www.statista.com/topics/2365/exchange-traded-funds/#dossierKeyfigures
{3} Sally Chen, Dimitris Drakopoulos, and Rohit Goel. (2019, June 19) China Deepens Global Finance Links as It Joins Benchmark Indexes. IMF Blog. https://blogs.imf.org/2019/06/19/china-deepens-global-finance-links-as-it-joins-benchmark-indexes
{4} By 2017, the three top stock index providers – S&P DJI, MSCI, and FTSE Russell – accounted for 27%, 26%, and 25% of global revenues in the index industry, respectively.
Johannes Petry. (2021, March 19) U.S. Investment in China’s Capital Markets and Military-Industrial Complex. U.S.-China Economic and Security Review Commission Hearing on March 19, 2021
https://www.uscc.gov/sites/default/files/2021-03/Johannes_Petry_Testimony.pdf
{5} US Security and Exchange Commission report. (2020, July 6) U.S. Investors’ Exposure to Domestic Chinese Issuers
https://www.sec.gov/files/US-Investors-Exposure-to-Domestic-Chinese-Issuers_2020.07.06.pdf
{6} Ibid.
{7} Ibid.
{8} Thinking Ahead Institute. https://www.thinkingaheadinstitute.org/research-papers/the-worlds-largest-pension-funds-2019
{9} 2020 U.S. State Department Annual Human Rights Report, Country Report on China.
https://www.state.gov/reports/2020-country-reports-on-human-rights-practices/china
{10} Office of the United Nations High Commissioner for Human Rights, (2021, June 14) China: UN human rights experts alarmed by ‘organ harvesting’ allegations.
https://www.ohchr.org/EN/NewsEvents/Pages/DisplayNews.aspx?NewsID=27167
{11} Freedom House, China Media Bulletin 151 – February 2021, China’s information isolation, new censorship rules, transnational repression
https://freedomhouse.org/report/china-media-bulletin/2021/chinas-information-isolation-new-censorship-rules-transnational
{12} U.S. Department of Justice, (2020, February 6) Christopher Wray remarks “Responding Effectively to the Chinese Economic Espionage Threat”
https://www.fbi.gov/news/speeches/responding-effectively-to-the-chinese-economic-espionage-threat
{13} Geopolitical Monitor, (2022, January 3), Backgrounder: China’s Military Modernization Comes of Age https://www.geopoliticalmonitor.com/backgrounder-chinas-military-modernization-comes-of-age
{14} Xie Yu. (2019, August 23) Why is Kangmei Pharmaceutical, found to have committed one of China’s biggest financial frauds, rallying? South China Morning Post.
https://www.scmp.com/business/companies/article/3024084/why-kangmei-pharmaceutical-found-have-committed-one-chinas
{15} Jing Yang and Serena Ng. (2020, November 3) Ant’s Record IPO Suspended in Shanghai and Hong Kong Stock Exchanges. The Wall Street Journal.
https://www.wsj.com/articles/ant-group-ipo-postponed-by-shanghai-stock-exchange-11604409597
{16} Celine Castronuovo. (2021, April 10) Chinese regulator imposes $2.8 billion fine on Alibaba. The Hill.
https://thehill.com/policy/international/china/547509-chinese-regulator-imposes-28-billion-fine-on-alibaba
{17} Bloomberg News. (2021, June 9) Why China Is Cracking Down on After-School Tutoring.
https://www.bloomberg.com/news/articles/2021-06-09/why-china-s-cracking-down-now-on-education-tech-firms-quicktake
{18} Coco Feng and Che Pan. (2021, September 23) China’s Didi Chuxing investigation closes in on 60-day mark with no conclusion in sight. South China Morning Post.
https://www.scmp.com/tech/big-tech/article/3149841/chinas-didi-chuxing-investigation-closes-60-day-mark-no-conclusion
{19} Sen. Marco Rubio. (2019, June 13) Rubio Requests Information from MSCI Over Controversial Decision to add Chinese Companies in its Equity Indexes.
https://www.rubio.senate.gov/public/index.cfm/2019/6/rubio-requests-information-from-msci-over-controversial-decision-to-add-chinese-companies-in-its-equity-indexes