If history is any guide, a win for China in getting its yuan shares into MSCI indexes this month would be bad news for South Korea.
Foreign funds pulled $470mn from Korean stocks on November 30, the day MSCI added half of the free float-adjusted market capitalisation of US listed Chinese shares but not those in Shanghai or Shenzhen.
NH Investment & Securities projects around $3bn could exit the smaller nation’s market in June should global funds have to make room for yuan- denominated A-shares. 
The index provider, which added the remaining half of the 13 New York-traded Chinese companies to the gauge on Tuesday, is proposing an initial 5% inclusion for mainland equities and will release its decision June 15.
Partial inclusion, which Goldman Sachs Group says has a 70% chance of happening, will probably be the first step toward full inclusion that would result in a big reduction of Korea’s weighting on MSCI’s Emerging-Market Index. MSCI will also announce whether the nation will win developed-market status this month, although Yuanta Securities Korea says the chances are “very low” due to the government’s reluctance to ease foreign-investment rules.
“A change in MSCI’s emerging-markets index would be bad news for Korea,” said Mun KyoungSeok, a managing director at Samsung Asset Management in Seoul. “The worst-case scenario is China’s A-shares are included in the index and Korea isn’t upgraded into the developed-market index.”
Foreign funds pulled $31mn from Korean shares on Tuesday, exchange data show, as the rest of the US listed Chinese shares were added to MSCI’s developing-nations gauge.
Partial inclusion of the A-shares will have a relatively minor impact on South Korea’s weighting, reducing it from 15.2% to 14.9% when they’re added in June 2017, according to the index provider. 
Subsequent increases would be subject to positive market liberalisation developments in China and full inclusion would reduce Korea’s weighting to 12.3%, MSCI said. While that would be a “huge disaster” for the local bourse, the addition of 5% of the A-shares won’t be too significant, said Kim Yong Goo, an analyst at Hana Financial Investment in Seoul. Getting to full inclusion is likely to be a very long process, said Frank Benzimra, head of Asia equity strategy at Societe Generale in Hong Kong.
Partial inclusion is still likely to be another blow to a stock market that’s taken a battering amid a slump in Korean exports that’s lasted for 16 straight months. Foreign funds have pulled $9.4bn from local equities over the past 12 months as the Kospi index fell 5.6%.
Blackrock, the world’s largest fund manager, raised its holdings of US listed Chinese stocks by 500% in February. Korean industrial companies will be one of the hardest-hit groups if the A-shares are included, according to a May 23 note from Ebest Investment in Seoul.
“The possibility of A-shares being added to the emerging index is already affecting Korean stocks,” said Hyun Choi, head of equities at Baring Asset Management Korea in Seoul. “It’s making investors reluctant to buy.”
Opinion is divided on whether a promotion to developed-market status would be good or bad for Korean equities. With a stock-market capitalisation of $1.2tn, South Korea is one of the bigger emerging nations. But it would be small compared with developed markets like Japan, which has a $4.9tn capitalisation, and the UK on $3.4tn.
“Now it’s a big fish in a small pond, but it would become a small fish in a big pond,” said Clive McDonell, head of emerging-market equity strategy at Standard Chartered Plc in Singapore. Developed status is the “greatest threat to the market,” rather than the addition of the A-shares, he said.
Hana Investment’s Kim disagrees, saying the only way for South Korea to prevent massive capital flight over time is to be included in MSCI’s developed index. While Stuart Rae, a portfolio manager at AllianceBernstein Hong Kong, doesn’t think it’s that big a deal which gauge the nation is in.
“The approach for global investors these days is to be less focused on the emerging market and developed market boundary,” he said. “If a company has good earnings, good corporate governance and a good competitive position, then we’ll buy the company.”
Korean authorities have been cautious in opening their markets completely to foreign investors, making an upgrade to developed status this year unlikely, said Lee Jung-Ho, an analyst at Yuanta Securities in Seoul.
Samsung Asset’s Mun cited the outflows after Vanguard Group Inc dropped Korean shares from its emerging-market exchange- traded fund in October 2012 as it started to track an index compiled by FTSE Group, which classifies South Korea as a developed market. Foreign funds pulled $1.6bn from the stocks over October and November 2012, exchange data show.
“What we are really worried about is a rapid, short-term shock,” Mun said. “Korean markets would probably be OK as the markets aren’t that fragile and there would be definitely people jumping in when the stocks become too cheap.”


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