Chinese A-shares to be included in MSCI EM index
In June 2017, index provider MSCI announced that domestic China A-shares will be included in its flagship Emerging Markets (EM) index for the very first time. The move should lead to substantial inflows of global assets over time into the Chinese domestic equity market, enabling foreign investors to broaden their exposure to the transforming Chinese economy.
Reforms gain international recognition
China is already a significant part of the MSCI EM index at a 28.55% weight.1 Currently, this includes only the Chinese companies listed offshore, including H-shares in Hong Kong (HK) and American Depository Receipts (ADRs) in the US.
In comparison, China A-shares are Chinese companies listed on the domestic exchanges, Shanghai and Shenzhen, and traded in Chinese renminbi. Up until recently, A-share investment had been restricted to domestic investors and Qualified Foreign Institutional Investors (QFII). Over the past couple of years, China has been liberising its financials markets and taken steps to open up the access routes for foreign investors to participate in the domestic equity market.
Shanghai and Shenzhen-HK Stock Connect
The launch of the Shanghai-HK Stock Connect in 2014 was an important step in this direction, followed by the Shenzhen-HK Stock Connect programme in 2016. These connect programmes essentially enable foreign investors to purchase A-shares through their HK broker, and for domestic Chinese investors to purchase HK listings through the mainland exchanges. The launch of the Stock Connect programmes were important factors leading to MSCI’s decision to include A-shares, having considered this for a few years.
New Chinese regulation
What prevented this from being approved during earlier consultations? Previously, concerns regarding monthly repatriation limits (under the QFII regime), suspension treatments and pre-approval requirements prevented the addition. Over time, Chinese authorities have introduced new regulation aimed at overcoming these issues and improving confidence within its financial institutions. Recent tangible reform of domestic financial markets includes the crackdown on shadow banking, increasing transparency through tighter information disclosure and reduced voluntary trading suspensions. Pre-approval requirements were also loosened.
Initial A-share inclusion is limited
The 222 large-cap A-shares that MSCI will include in its EM index will be introduced in two index reviews in 2018. However, this comes out of 3,325 A-shares listed in Shanghai and Shenzhen.2 Additionally, the 222 companies selected will represent only 0.73% of the MSCI EM index.3 Despite the low inclusion rate of 5%, this is an important symbolic step to expand the domestic Chinese market to foreign investors.4 The MSCI EM Index is tracked by approximately $1.5 trillion,5 with the initial inclusion estimated to draw a modest $17 billion6 foreign flow into the A-share market (which itself holds a $8.31 trillion market cap7).
The future inclusion in global EM indicies of small-mid cap A-shares will occur when ‘further alignment with international market accessibility standards occurs, sustained accessibility is proven within Stock Connect and international institutional investors gain further experience in the market’.8 Full A-share inclusion could lead to Chinese companies accounting for 40% of the MSCI benchmark.9 However, this is expected to be a long way down the road; it took six and five years respectively for South Korea and Taiwan to be fully included in global indicies.
Opportunity knocks at the door only once (Chinese proverb)
The majority of A-shares are not the large state-owned enterprises many international investors are familiar with. Investing in the broader area of the market provides better access to the country’s economic drivers, including exposure to consumer spending-driven stocks and the country’s growth in fintech. This is attractive given China is set to overtake the US and could become the largest economy in the world by 2030.10 A-shares have historically had a low correlation with H-shares and other global markets making it an attractive diversifier for investors, while active stock pickers can take advantage of current attractive valuations.
Avoid relying solely on an EM mandate or an EM index tracker
While this is a positive start to greater financial market liberation in China for all, investors may miss out on the broad set of opportunities available within China’s growth engine if relying solely on a global EM mandate to gain exposure to the market, or passively tracking an EM index. Given the bright future ahead for the Chinese economy and greater focus on the region by international investors, we believe there is no better time to make the most of potential alpha opportunities deeper within the Chinese market with a specialist investment manager.
1 MSCI. Emerging Market Index as at July 2017.
2 BBG000L6JSP3 SZASHR Shenzhen Stock Exchange AShare Index: 2,010 members. BBG000L6JTY1 SHASHR Shanghai Stock Exchange A-Share Index: 1,315 members.
3 MSCI. Results of the MSCI 2017 Market Classification Review Press Release. 20 June 2017.
4 MSCI. Consultation on China A-Shares Index Inclusion Roadmap. June 2015.
5 MSCI. As of Dec 31, 2016, as reported on March 31, 2017 by eVestment, Morningstar and Bloomberg.
6 CBNC. Roughly $17 billion or more could now flow into Chinese stocks, MSCI exec says. 20 June 2017.
7 Bloomberg. Shenzhen Stock Exchange A Share Index and Shanghai Stock Exchange A Share Index market cap CNY55.37 trillion (US$8.31 trillion).
8 See footnote 3.
9 See footnote 4.
10 PWC. The Long View: How will the global economic order change by 2015? February 2017.