A number of our clients have been discussing with us the long-standing, but only recently broadly recognised issue of Chinese A-share companies listed on Shanghai and Shenzhen using their ability to unilaterally decide to suspend their own shares for periods of up to six months, in order to reduce or avoid price falls. More worryingly, the reason for doing so is suspected to often be to avoid the companies or their owners receiving margin calls on loans taken out against their own shares.
The result of these suspensions is, from the point of most investors, their inability to then sell their holdings during the suspensions, leading to unwanted risk. The issue however perhaps bears down more heavily on index providers, as they generally follow constituent eligibility rules that remove from their indices a suspended company that’s remained suspended for more than a month or so, at a price of zero. This is done in the face of evidence (from most other markets) that a company suspended for a longer period is unlikely to return to the market, meaning that it is appropriate for the index to remove the company, even though that crystallises a loss for those passively-managed products tracking their indices. If the company does however return to the market, as many of these A-Shares do, tracking funds will book an unearned outperformance relative to the index, as they now own shares that have a value, despite having been removed from the index at zero. A resolution is unclear. The index provider could increase the required suspension period before removing a company, but that would have to be China-specific to avoid damaging the rule’s usefulness elsewhere. One provider, MSCI, has instituted a rule whereby a Chinese company that has had a suspension period of more than 50 days is ineligible for their indices. This should act as a deterrent, but in the view of our clients, may not have much of an impact upon the actions of the companies. If however the likelihood of a company that’s suspended itself once doing so again is significantly higher than the likelihood of any other company announcing a suspension, then slowly the “suspension effect” will reduce in the index, at the cost of removing a proportion of the A-Share market from eligibility, i.e. making the index less representative of the overall opportunity set.
Helpfully, the Shanghai Exchange has stated its intention to clamp down on the practice. But until they do so, and its efficacy is certain, the major index providers are in the uncomfortable situation of having announced the inclusion of A-shares in their broad global indices, while a notable A-share specific problem remains extant. 15 September 2018