On June 1, the index provider MSCI officially added 226 Chinese mainland-listed stocks to its flagship emerging markets indices, such as the MSCI Emerging Markets Index (this index is used as benchmark for approximately USD 1.6 trillion of assets globally). This represents a milestone for the integration of A-shares into the global capital markets. We see this as a key development in the opening of China’s financial markets to overseas investors.
The stocks that MSCI is adding range from financial stocks to industrials and consumer staples. The number of stocks (226) MSCI is adding is a relatively small portion of China’s 3000+ renminbi-denominated A-shares but we expect it will rise as China’s markets become increasingly accessible and capital controls are removed.
A gradual process of integrating Chinese stocks
This announcement is the latest step in a process that began in June 2013 when MSCI announced that it would include A-shares in its global benchmark EM equity indices for the first time. All stocks to be included by MSCI will be large-capitalisation shares currently accessible to foreign investors through the Stock Connect schemes (which links Hong Kong with Shanghai and Shenzhen without subjecting investors to the same restrictions they would face buying shares on Mainland China). The inclusion includes some onshore China large-cap shares that have offshore share equivalents in the MSCI China index.
The inclusion will be in two phases: a 2.5% inclusion factor on June 1, and a 5.0% inclusion factor on September 3. At a 5% inclusion factor, A-shares will account for approximately 0.8% of the MSCI Emerging Market (EM) index and will bring USD 22 billion in inflows into the A-share market, according to MSCI’s estimates. Although the impact on fund flows will be minor over the short term, we believe that the long-term implications would be sizable. USD 360-400 billion of inflows are expected over the next five to 10 years, according to our Greater China senior strategist, Chi Lo. We expect the weighting will rise significantly over time. At full inclusion, A-shares could account for 16.2% of the MSCI Emerging Market index. It took South Korea six years and Taiwan nine years to gain full inclusion within the MSCI indices. Both South Korea and Taiwan started with much larger open capital account positions than China has today. Given the size, access and capital mobility constraints, it may take longer for A-shares. To secure full inclusion, China will need to open its capital account further and increase foreign ownership of stocks more significantly.
China-related stocks already make up around 32% of the MSCI Emerging Markets index but these are shares that are listed offshore in Hong Kong, the US and elsewhere. They are therefore subject to different regulation than A-shares. Nonetheless, if their weighting is aggregated with that of A-shares after “full inclusion”, China’s total weighting in the Emerging Markets benchmark index would be over 40% reflecting the importance of China’s economy within emerging markets.
The potential Chinese equities offer in the long run
In our view there is little doubt of the potential Chinese equity markets offer in the long run. There is already a distinct opportunity given the relatively small weight Chinese equities have in global indices relative to their huge size by market capitalisation and increasing tradability. Although the MSCI inclusion of A-shares will initially be small in scale, we believe it will help improve global interest in China’s A-share markets and encourage inflows into China.
China’s A-shares market is the world’s second by capitalisation (behind only the US). Foreign investors are reckoned to hold 2% of it in their global portfolio. Mainland China retail investors account for 83% of trading turnover in A-shares. Although this proportion for retail investors has slightly decreased, it will be a gradual process before the market becomes more institutional.
We believe inclusion in the MSCI indices is a positive catalyst for Chinese equities and is of ‘symbolic significance’ to China as it is a signal of international recognition of China’s market liberalisation. The opportunities in the Chinese equity markets today are too big to ignore, but China’s market requires local expertise to navigate its waters successfully. We expect China to provide an increasing number of global market leaders, which offers the opportunity for long-term investors to benefit from holding Chinese companies in enhancing the risk-return profiles of their portfolios.
The value of investments and the income they generate may go down as well as up and it is possible that investors will not recover their initial outlay.
Investing in emerging markets, or specialised or restricted sectors is likely to be subject to a higher than average volatility due to a high degree of concentration, greater uncertainty because less information is available, there is less liquidity, or due to greater sensitivity to changes in market conditions (social, political and economic conditions).
Some emerging markets offer less security than the majority of international developed markets. For this reason, services for portfolio transactions, liquidation and conservation on behalf of funds invested in emerging markets may carry greater risk.