Explainer-What is MSCI and what has it done to Indonesia’s stock market?

By Gregor Stuart Hunter

SINGAPORE, Jan 29 (Reuters) – MSCI is a powerhouse within the $139 trillion asset management industry and its decisions are hugely consequential for countries around the world – as Indonesian investors learned this week to their cost.

The Jakarta Composite Index plunged by as much as 16.7% in the past two days, after an MSCI warning that a possible downgrade to frontier market status from emerging markets triggered a wave of capital flight. The index recovered later in Thursday’s trading session, but still closed down 1.1% to log a second consecutive day of decline.

WHAT IS MSCI?

Formerly known as Morgan Stanley Capital International, the company’s index products are one of the biggest and most important reference points for stock markets around the world. It does no investing of its own, but decisions on which countries and companies to include in its flagship Emerging Markets Index, which tracks some $10 trillion of stocks, can carry enormous weight with global investors.

Index compilers, including FTSE Russell and S&P Global, have reshaped the global investment landscape as exchange-traded funds around the world have grown in popularity – and clout.

For active fund managers and index trackers alike, MSCI’s decisions on which countries and companies to include or exclude can force automatic rebalancing of portfolios and billions of dollars of capital flows.

WHAT DID MSCI DO TO INDONESIA AND WHY DID THE MARKET FALL?

MSCI said in a statement that clients flagged problems around market data that obscured what proportion of Indonesian companies’ shares could be freely traded and how the exchange categorised stock owners.

The index provider said its clients pointed to opaque shareholding structures and coordinated trading behaviour by market investors undermined “proper price formation”.

MSCI has given Indonesia until May to show signs of progress, at which point it will reassess its status. That could result in a lower weighting for Indonesia in its emerging market benchmark, or even a downgrade to frontier market status.

It was that threat which caught investors by surprise, and triggered a stampede towards the exits.

WHAT HAPPENS IF INDONESIA GETS KICKED OUT OF THE EMERGING MARKET CATEGORY?

Upgrades and downgrades by MSCI have had enormous implications for countries and markets in the past and are likely to weigh on Indonesian markets for a while.

Goldman Sachs estimates that foreign investor outflow could reach $7.8 billion if Indonesia is downgraded to frontier market, a scenario the investment bank and some investors deem unlikely.

Indonesia accounts for about 1% weighting in the MSCI emerging markets, which is dominated by China, Taiwan and India. Whether MSCI’s move spurs other index providers remains to be seen. FTSE Russell said it was monitoring the situation closely.

WHAT DOES INDONESIA SAY – AND WHAT HAPPENS NEXT?

Index reclassification consultations typically take months or years to be made effective, but foreign investors do not have much incentive to hang around when they know that a wave of money is due to roll in – or out.

That puts the ball back into the Indonesian government’s court. Indonesian financial authorities said on Thursday that the government accepted the index compiler’s views as “good input”. They added that their communications with MSCI had been positive and they were awaiting a response to proposed measures, which include doubling the free float requirement on listed firms to 15%.

The government has shown a willingness to punish foreign firms for downgrading its markets in the past. It penalised JPMorgan Chase & Co in 2015 after the investment bank’s research arm recommended a smaller exposure to the country’s bonds, and again in 2017 when it issued a similar rating on its stocks.

(Reporting by Gregor Stuart Hunter; Editing by Alison Williams)