(Bloomberg) -- Short selling could get a little bit easier in China after the country’s domestic stocks join MSCI Inc.’s big index club.
MSCI’s inclusion of onshore-listed Chinese shares next month will be a step toward increasing the pool of stock that’s available to borrow. Share lending in the country is virtually non-existent, compared to the U.S. or Europe where the practice often makes up about 20 percent of daily turnover. In just a few weeks, some $1.9 trillion of index-tracking money linked to MSCI is about to own equities in China for the first time.
Formidable obstacles currently face international investors wanting to hedge or short yuan-denominated shares. They can use a stock link with Hong Kong, though only certain members of the city’s exchange can borrow and lend shares through that program. Custodian banks, the firms that most institutional funds will use to clear their assets, are not typically on that list. All short orders need to be flagged and there’s a 1 percent daily limit on any stock.
The result: overseas investors haven’t sold a single Shanghai or Shenzhen stock short via the link with Hong Kong in the past month, exchange data show.
“The biggest issue with short selling in China is the availability of stock to borrow,” said Seth Fischer, chief investment officer of Oasis Management Co., a Hong Kong-based hedge fund. “MSCI inclusion will likely help improve availability.”
While the demand to borrow A shares -- a tool that’s essential for hedge funds wanting to protect their positions or speculate on price declines -- is likely to rise as the country gradually opens up its financial markets to international investors, the scarcity of stocks on loan has so far limited the practice through official channels like the stock connect.
Short selling gained a bad reputation in China after it was partly blamed for the market’s spectacular crash in 2015, with many leveraged punters betting against the whole market via index futures. Curbs that were put in place at the time largely shut out bearish speculators, similar to what was done in France, Italy, Spain and Belgium to reduce volatility at the height of the European sovereign-debt crisis in 2011.
China’s restrictions on derivatives and short selling mean prospective international investors may find it tricky to hedge. While mom-and-pop investors account for about 80 percent of trading in the country’s $7.6 trillion onshore equity market, MSCI has said that the initial inclusion plan will bring more than $17 billion of foreign institutional money to the Chinese market, rising to as much as $35 billion once MSCI increases the stock universe.
The government is accelerating capital-market reforms on most fronts. Just in the past few months, it started a debate on dual-class shares, announced plans to introduce CDRs, raised limits for investors buying stocks through Hong Kong, said it will add another stock trading tie-up with London and opened up its local securities joint ventures to Wall Street ownership. That’s a bullish sign for those seeking engagement on securities lending.
“We’ve seen a significant shift in tone in Beijing from September to now,” said Lyndon Chao, head of equities at Asia Securities Industry & Financial Markets Association, a trade group based in Hong Kong. “There’s clearly a willingness from China to open up its capital markets, attract overseas investment and make China compete with the rest of the world. The door appears to be wide open.”
Champions of stock lending say short sellers make markets more efficient and help keep checks on corporate governance -- take Hong Kong as an example -- while also providing another source of income to the asset-management industry. Managers of tracker funds often lend up to a third of their holdings in return for a fee and collateral. Those payments from borrowers contribute to the fund’s returns, giving them extra yield. Asian equities lending generated $1.1 billion in revenues last year, according to IHS Markit Ltd. data.
New York-based MSCI will announce the results of its global index review on May 14, with all A-share additions effective after the close on June 1. Brokerages are preparing for a surge in interest, with JPMorgan Chase & Co. planning to expand its equity research team covering Chinese companies by more than 50 percent this year.
“MSCI is likely to be a catalyst event,” said ASIFMA’s Chao. “Eventually, through the institutionalization of the market when more asset managers, insurers and pension funds start to own China A shares, the supply for securities lending will grow.”
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