Enter the Dragon: Figuring China Into the Asian Equation

Morgan Stanley Capital International is altering the makeup of its Asian indices.
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HONG KONG -- Starting June 1, mutual funds that invest in Asia will be taking a much greater interest in China, whether they like it or not. And regardless of what investors in international stocks think about China's prospects, they too should take note, because more attention to China could mean less attention to other Asian markets.

The reason for increased interest in the world's most populous country is no mystery.

Morgan Stanley Capital International

, which sets the benchmark indices against which many mutual funds rate their performances, is altering the makeup of its Asian indices. More emphasis will be placed on Chinese stocks, while the region's blue-chips in Hong Kong and Singapore will likely be pruned.

The way the indexers see things, China will become the fourth-largest Asian market outside of Japan. "It will have a negative impact on peripheral markets such as the Philippines, Thailand and Indonesia," says Billy Chan, one of the managers of the

Invesco China

fund, which isn't listed in the U.S.

The shift in emphasis to China could eventually change the way international investors pick their mutual funds, because as things have stood, China country funds have tended to underperform Asian regional funds, such as the

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Matthews International Pacific Tiger or the

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T. Rowe Price New World Asia funds.

The Morgan Stanley Standard

Why will the terrain in Asia change? Just as an entry to or exit from the

Dow Jones Industrial Average

can help or hinder a company's profile, so it is internationally with a thumbs up or down from Morgan Stanley's indexers.

As June 1 approaches, some stocks included in the index will likely rise, although the biggest one by far,

China Telecom

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, has already rocketed so far this year that Morgan Stanley is counting it at only 40% of its market value, lest it become the index all by itself.

Morgan Stanley's action acknowledges what investors have known to be true for some time: China's state-owned companies incorporated inside China, and listed either in China or Hong Kong (the latter stocks are known as H-shares), have been sad underperformers. Often, it's been their own fault, as many have tended toward woeful disclosure and even worse management.

Red-Chips and H-Shares

Currently, investor favorites have been companies like China Telecom, owned by mainland interests but incorporated in Hong Kong. These companies are known as red-chips, and a pile of these will be going into the new China index at the expense of many H-shares and other stocks.

MSCI says it is reshuffling its index in order to allow for "a better representation of the investment opportunities that are available to foreign investors."

For now, Morgan Stanley is simply recognizing that some H-shares in its old index have dropped off investor radar screens, but its reweighting promises bigger consequences in the not-too-distant future.

"It's an important step in the direction of recognizing, number one, that China is becoming an important market for institutional investors," says Scobie Ward, co-manager of the

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Eaton Vance Greater China Growth fund.

Well before the MSCI changes, Ward's top holding was China Telecom. His fund, up 80% this year, is one of the better China products on the market, although with a front-end load of 5.75% and expenses of 2.33%, it's not cheap to own.

"China Tel and

Citic Pacific

are important companies," says Ward. (Citic, the Hong Kong subsidiary of Beijing's investing arm, will also be added.) These "are the ones institutions can and would want to have large stakes in," says Ward.

China's image overseas could do with the scrubbing. Absent any short-term fads, such as the ones that enveloped H-shares in 1994 and even the shoddiest of red-chips in 1997, investors will always want to see that a money-raising company is based and traded in a place with decent disclosure and liquidity.

Taking Stock of Chinese Stocks

Even then, with their patchy histories, selling Chinese stocks outside the telecom sector can be difficult these days. Take

PetroChina

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, the big state oil company that began trading this week. It was listed not in China, but in Hong Kong and New York.

Despite this comfort factor, PetroChina's offering had to be bolstered by getting major Hong Kong companies controlled by property tycoons such as

Li Ka-shing

to kick in hundreds of millions of dollars at the last minute to help the flagging offering.

Not only are China's foreigner-eligible domestic markets too illiquid for a $3 billion issue, but, as likely as not, foreigners wouldn't have gone for it.

PetroChina wasn't issued early enough to make it into the China index this time around, but look for its addition in the next revamp.