At an inclusion factor of 5 per cent (by August), split across 234 names, China A-shares will account for roughly 0.8 per cent of the MSCI Emerging Markets Index, 1.1 per cent of the MSCI Asia ex-Japan Index and a blink-and-you’ll-miss-it 0.1 per cent of the MSCI AC World Index.
Considering there are around 3,500 companies listed on the Shanghai and Shenzhen exchanges, this partial inclusion might seem more token gesture than step change. MSCI has fairly good reason to start small. If A-shares suddenly appeared in indices at a ratio reflecting their true size, hordes of investors would rush in to rebalance their portfolios, knocking markets off kilter in the process.
Perhaps more significantly, partial inclusion reflects an investment environment still in its infancy and prone to governance hiccups. For a long time, most international investors keen to venture into the thick of mainland markets simply couldn’t. Exposure was predominantly via large and relatively well-known Chinese companies listed on exchanges in Hong Kong or Taiwan, or the Asian US dollar bond market.
That is, until China started to see the upside of foreign capital and nudged open its doors. Firstly through quotas for selected qualified institutional investors (QFII and RQFII) and later via Stock (and Bond) Connect - a gateway between mainland and Hong-Kong based exchanges. In fact, the Connect programmes proved to be the turning point in inclusion deliberations.
MSCI assesses a market’s suitability for index inclusion based on five key criteria: openness to foreign ownership, including qualification requirements, ownership limits and equal rights for foreign investors; ease of capital inflows/outflows; efficiency of the operational framework, including market regulations and information flow; competitive landscape; and stability of the institutional framework. But there is still some way to go in both foreign access and overall confidence. Most international investors depend on Stock Connect to buy and sell onshore assets, making them vulnerable to any sudden moves by authorities to rescind or restrict the programme.
Meanwhile, the Chinese equity market is highly liquid, but its investor base has a strong retail tilt and can be volatile with flighty sentiment. To tackle this, when such behaviour sparked a market freefall in 2015 the government established a so-called ‘national team’, comprised of state-owned financial institutions, whose chief objective was to buy and hold A-shares to restore market stability. They still own a decent chunk and stand as a potent reminder of the potential for market intervention – which might not always go in favour of investors, be they Chinese or foreign.
Another case: the ill-fated circuit breaker introduced by regulators in 2016 to limit downward pressure on prices amid intense volatility. In reality, it led to hundreds of share suspensions and an attack of the jitters that spread to markets around the globe.
Many companies have opaque ownership structures and do not adhere to the same standards of reporting and transparency that most international investors have come to expect. The truth is, without an on-the-ground, experienced research presence, investing in the mainland can be a formidable prospect; which is one reason why foreign investors hold only slightly more than 2 per cent of the onshore equity market.
However, in the wake of A-share inclusion investors can no longer ignore China, even if they wanted to. And therein lies its significance, regardless of the numbers. Investors who pay even the merest allegiance to a benchmark will have to attend to a collection of (to them) largely unknown Chinese companies in which they might now be compelled to invest.
Along with foreign capital come plenty of questions and expectations of accountability, of course. This is no bad thing if it spawns a more transparent and shareholder-friendly corporate environment. And, combined with the growing institutionalisation of onshore capital markets, driven by fundamentals rather than short-term noise, this should inspire confidence among ever greater numbers of international investors.
It’s a similar picture for China onshore bonds, which have already been included in several indices. However, it’s their inclusion (earmarked for 2019) in more widely tracked benchmarks like the Bloomberg-Barclays Global Aggregate that will be closely watched, with expectations they could spur more than US$280 billion in inflows and a healthy dose of scrutiny.
So index inclusion should add a dash more credibility to China’s onshore markets. Although, foreign investors who embedded themselves in the mainland years ago, and who’ve spent that time on extensive research, might add that the exposure indices offer barely scratches the surface of the opportunities China presents.
Consider this: at 100 per cent index inclusion China would account for around 41 per cent of the MSCI Emerging Markets index (A-shares and offshore equities combined) and almost 55 per cent of the MSCI Asia ex Japan index, which makes the latter look rather more like a single country fund. This isn’t going to happen this year, or probably even within the next few years. However, it paints a rather powerful picture of China’s financial prominence and potential dominance in the region. Take China’s arrival on the international investment scene seriously now or find yourself vying for space in a very crowded pool - and paying all the more for it.
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