The Hidden Implications of Global Index Re-Weightings

In the midst of a Capital War, the China Lobby is deftly pushing for American retirees and pensions to help fund an asset bubble in China, and their vehicle of choice is the ubiquitous index fund.

By Chris Recker  ▪  December 18, 2019
Featured Image

Today, the United States is being confronted with an Unrestricted, All Domain War being executed by the Chinese Communist Party (CCP) and the People’s Liberation Army (PLA). On one front a Capital War is being waged, in which China is trying to prop up its domestic asset bubble by steering U.S. dollars into their country.  

To advance its agenda, China has enlisted a de facto China Lobby, comprised of some prominent U.S. individuals and multinational corporations, who advocate investment in China.

In my opinion, the China Lobby is making a Faustian bargain.

Part of a Broader Capital War

These efforts are all part of a broader capital war. What is a capital war? It is a war over the capital account, or the flow of money and investment between countries. It is about currency and foreign exchange reserves. Since the Chinese Renminbi is not freely convertible, this particular capital war is about the U.S. Dollar and how China’s financial system interacts with the rest of the world. In other words, China needs your money.

The essential questions at stake are: 1) should Americans invest in China, and 2) should the CCP and PLA be allowed to invest in American assets and technology?

Global Index Re-Weightings Have Security Implications

As an example of CCP tactics look no further than the recent push to re-weight international bond and stock indexes. When index providers, such as Vanguard and MSCI, assign China a larger weight among portfolio holdings, the immediate result is additional capital flow into China from investors in these products – largely pensions and individual investors.

In other words, these international indexes have become a conduit to help bail out CCP/PLA macroeconomic mismanagement. Rather than hastening the collapse of a U.S. adversary, new index weightings would effectively support the CCP.

American Investors Provide the Dollars, Assume the Risks

The China story has been central to the global growth model for the past two decades. But today, China’s asset bubbles, industrial overcapacity, and currency risk have perhaps become the greatest economic threats to markets and the world financial system, and at the same time the world’s investment exposure to China is greater than it’s ever been.

The prolific use of index investing has concentrated a huge amount of money into a limited set of investments, and it has given power to the companies in charge of directing those resources. Every index is comprised of investments that make up a certain percentage, or weight, of the total holdings. These weights are determined by the firms that create the indexes, and they effectively determine how much money flows to different parts of global stock, bond, and real estate markets. Geography is one of the weighting factors.

For example, the Vanguard FTSE Emerging Market ETF (VWO) drives nearly half of its assets to China and Taiwan, which have weightings within that index of 35.2% and 14.7%, respectively. The iShares MSCI Emerging Markets ETF (EEM) holds nearly 43% of its assets in China (31.8%) and Taiwan (11.4%).

This type of geographic concentration is less of an issue for international indexes comprised of “developed” countries (i.e. EFA/IEFA), where direct China exposure is not a top factor. However, the capital flows can be even larger and more impactful in the bond indexes, which hold much larger dollar amounts compared to equity indexes.

Because index funds are widely held by American retirees and pension funds in their investment portfolios, it is the American investor that, in a roundabout way, ends up providing the funding and assuming the risks related to China’s economic issues.

China’s Imbalanced Financial System

Over the last decade, China’s financial system assets and money supply (M2) growth ramped to new heights, but reserves in the capital account declined. This presents a terrible risk for the CCP, since its currency could face near collapse.

Adding fuel to the fire, the quality of assets in China’s system is highly speculative. According to the IMF, a large fraction of assets in the banking system could be at risk in an adverse economic scenario. It also suggests recent growth has come through unproductive investment. 

The CCP created $25 trillion equivalent Renminbi in its domestic money supply that is backed by hard convertible currency in the rough amount of $3 trillion. Perhaps, CCP controlled entities have a net foreign investment position of another $1.5 trillion.

The result is potentially too much CNY chasing too few hard currency reserves, and it would stand to reason for the CCP to be worried about its USD position.

With scarce dollars, declining reserves, and declining trade prospects, China risks a currency collapse as capital continues to flee CCP authoritarianism.

CCP Response: Direct US Savings to China

How does China keep its train on the tracks? Get more U.S. dollars.

The CCP revised the Foreign Investment Law on March 15, 2019 raising the limits on foreign investment beginning January 1, 2020. The CCP strong-armed U.S. index providers to change the composition of emerging market indexes to raise the weighting of China.

Providers that have upped China weights in their indexes include MSCI, Inc., J.P. Morgan Chase & Co. and Bloomberg Barclays Global Aggregate Index.  FTSE Russell has placed China on its watchlist for potential upgrade in weightings. This would result in $100’s of billions of U.S. pension and investor money into the CCP coffers through Chinese stock, bond, and private markets. Even without a great power conflict, China's asset and FX bubble likely make this a dicey investment proposition.

As the China Lobby smoothly pushes its agenda, America and its allies can still own the high ground in this Capital War, and index re-weightings may be a good place to consider.


The views and opinions expressed herein are those of the author and do not necessarily reflect the views of AZA Capital Management ("AZA"), its affiliates or its employees. This document has been provided to you solely for information purposes and does not constitute an offer or solicitation of an offer or any advice or recommendation to purchase any securities or other financial instruments and may not be construed as such.

The factual information set forth herein has been obtained or derived from sources believed by the author and AZA to be reliable, but it is not necessarily all-inclusive and is not guaranteed as to its accuracy and is not to be regarded as a representation or warranty, express or implied, as to the information’s accuracy or completeness, nor should the attached information serve as the basis of any investment decision. Past performance is not a guarantee of future performance.

This material is not research and should not be treated as research, and does not represent valuation judgments with respect to any financial instrument, issuer, security or sector that may be described or referenced herein and does not represent a formal or official view of AZA. The views expressed reflect the current views as of the date hereof and neither the author nor AZA undertakes to advise you of any changes in the views expressed herein. It should not be assumed that the author or AZA will make investment recommendations in the future that are consistent with the views expressed herein, or use any or all of the techniques or methods of analysis described herein in managing client accounts. AZA and its affiliates may have positions (long or short) or engage in securities transactions that are not consistent with the information and views expressed in this document.

The information contained herein is only as current as of the date indicated and may be superseded by subsequent market events or for other reasons. Charts and graphs provided herein are for illustrative purposes only. Nothing contained herein constitutes investment, legal, tax or other advice nor is it to be relied on in making an investment or other decision. There can be no assurance that an investment strategy will be successful. Historic market trends are not reliable indicators of actual future market behavior or future performance of any particular investment which may differ materially and should not be relied upon as such. This material should not be viewed as a current or past recommendation or a solicitation of an offer to buy or sell any securities or to adopt any investment strategy.

The information in this document may contain projections or other forward-looking statements regarding future events, targets, forecasts or expectations regarding the strategies described herein and is only current as of the date indicated. There is no assurance that such events or targets will be achieved, and they may be significantly different from that shown here. The information in this document, including statements concerning financial market trends, is based on current market conditions, which will fluctuate and may be superseded by subsequent market events or for other reasons.

Information contained on third party websites that AZA may link to are not reviewed in their entirety for accuracy and AZA assumes no liability for the information contained on these websites.

No part of this material may be reproduced in any form without express written permission from AZA.