Where Is China Going, Given The MSCI Rejection

| About: iShares China (FXI)

Summary

The MSCI rejected China's bid to become included with the MSCI Emerging Markets index while Pakistan has been included.

Although Chinese leaders have been working very hard in recent decades to become more and more a part of the world, there is concern that President Xi may be backtracking.

This may be a short-run case because of current political pressures, but China, for the longer haul, knows that it must open up, reduce capital controls and cooperate.

China has worked for years to modernize its economy and to change how it does business, in order to play the role in world markets it believes that it should be playing.

Last August, the International Monetary Fund moved to include the Chinese currency, the renminbi, in the list of currencies it accepts as reserve currencies. If this goes through, the renminbi will join the club of primary currencies like the US dollar, the British pound, the Japanese yen, and the euro as the only sanctioned reserve currencies in the world.

Chinese leaders were quite proud, as they well should be. China was becoming a member of the elite.

Now, however, it has received a setback to its move into world financial circles.

The MSCI, the Morgan Stanley Capital Index, a group that produces a number of market indexes, failed to include Chinese shares in its emerging markets index. It was a clear snub to China and a setback to China's plans to become a full member of the major economic nations of the world.

The snub seemed even worse as Pakistan qualified for the MSCI Emerging Markets Index.

The primary reason for the difference in treatment: capital controls.

Even though the Pakistan stock market is only one-hundredth of the size of the market on mainline China, it was upgraded into the index because of the capital mobility in and out of the country.

Capital controls was one of the major reasons given for the denial of the Chinese market, although there were other factors like overly extended regulatory efforts and "unique local market practices."

In recent years, China has seemed to support the lessening of capital controls along with the efforts to expand the use of its currency worldwide, and along with the rapid growth of its export trade. These efforts have been consistent with the thrust of the central government to reduce barriers to trade, increase openness, and free up corporations and markets to compete with other areas of the world.

There is concern, however, that Chinese leaders, especially President Xi Jinping, have been reversing some of the government's positions on the move to freer markets.

Traces of this reversal have been noted by analysts over the past year or so as President Xi has moved to reduce corruption in both the political ranks as well as in the business circles. This has cost the leader political capital and he has gotten more resistance in recent efforts to free up the currency markets, as well as the capital markets. The August upheaval and resulting volatility especially caused President Xi and other Chinese leaders to question the speed at which changes were being made.

The one thing that we must remind ourselves about, however, is the Chinese tendency to think in terms of decades rather than months or years, as we do in our Western societies.

President Xi, I still believe, is committed to freeing up Chinese industry and Chinese markets over the longer run. Political needs may be delaying this for the short run.

China wants to become a world class competitor on the economic front and, deep down, its leaders know that this means that China will have to open up more, will have to become more competitive and will have to reduce controls on capital movements. I believe that it knows full well that unless it becomes more and more capitalistic in operation, it will not be able to achieve the position in the world that it wants.

I believe that it also knows that world trade and globalization are going to continue to expand, that information is going to continue to spread and that nations are going to have to work more closely together.

Just as we see that US policy makers are having to include Chinese actions and consequences in their decision-making process, as is the rest of the world; Chinese policy makers are going to have to be cognizant of how they are interacting with the rest of the world.

This, to me, is the world of the future. Some in Great Britain may want to leave the European Union, but the world is coming together not moving apart; and sooner or later, whatever the outcome of the vote, Great Britain is going to find itself more and more entwined with the EU.

And, the EU faces its own destabilizing issues and although it has a unified currency it does not have a unified political organization to back it up. Hence, it too faces the forces of disintegration.

But, as I mentioned above, the growth of world trade and globalization is not going to stop, even if it pauses for a moment. The flow of information throughout the world is not going to end, and this will bring us, for better or worse, even closer together. It always has and it always will.

And, within this world, nations are going to have to give up more and more of their national sovereignty and work more closely together. I think that the Chinese leaders really know this. It might just take us a while to get there.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.