Change to MSCI index could make China market even more volatile

The China indices are heavily weighted to the state-owned enterprises that used to dominate the economy but now account for far less than half the country's output, especially those in the three sectors of banks, energy and telecoms companies. By contrast, Tencent, the online gaming company that has morphed into social media, and owns WeChat, is the only new-economy stock in the index.

The list of companies that will be included and is making the rounds of investors and brokerage firms in Hong Kong includes Alibaba, Baidu, JD, Netease, Ctrip, 58.com, VIPShop and Qihoo 360. The change will force investors whose performance is measured against benchmarks such as the MSCI EM index to increase their holdings of these shares.

The change will also mean the entrepreneurs will have new leverage in their negotiations with backers, making the private market even more bubble-like. Ego is already playing a big role in the market as hedge funds and venture capitalists spar to take ever bigger pieces of deals - only to later syndicate them out to lower echelons of the financial food chain, taking a substantial fee in the process.

Those lower echelons include family offices and mutual fund firms such as Fidelity that are weary of waiting for initial public offerings in companies whose market debuts are constantly deferred. Banks such as JPMorgan are expanding their private markets desks to get a piece of the action. The question, of course, is whether this change will improve the quality of companies included in the indices and contribute to more stability in the market or simply feed the bubble. The amount of traffic these companies generate is impressive - the mobile internet generation is very different from the new economy bubble at the turn of the millennium. Including the higher quality tech names that are listed in the US rather than their lower quality A-share rivals is an improvement.

Yet many of these companies are burning cash and subsidising consumers in their efforts for ever more traffic. In some cases they have combined to derail a potentially larger threat, as did Didi and Kuaidi in the face of Uber's planned entry into their home market. At other times, their investors have forced them to combine, as was the case with 58.com and Ganji.com. But Ctrip and Qunar have twice discussed merging then decided against. Both recently raised more capital to finance their rivalry.

The steeper the valuation, the greater the risk - even in the private market. The dynamic is similar to that in the property market, when one bidder overpays vastly and everyone else marks their portfolio up. If there is a big correction in perception and a dramatic series of down rounds - where a later round is done at a discount to the previous one - valuations could fall dramatically.

By contrast, state-owned enterprises may not be rising stars, but at least they tend not to be shooting stars either.

Financial Times