Although some issues remain, there is a growing consensus among market participants that the inclusion of Chinese onshore shares (A-shares) in MSCI indices is increasingly a matter if ‘when’ rather than ‘if’. And, while the markets wait for this week’s decision from the MSCI, it’s worth reminding ourselves what this means for pension funds and other institutional investors.
We are now into the third year of discussion and debate on the inclusion of China’s domestic equity market to the major indices. Both major index providers, FTSE Russell and MSCI, have over the last three years spent a tremendous amount of time discussing with beneficial owners, regulators, stock exchanges, and the market in general on whether China should be added to emerging market indices.
The closest scrutiny by far has come from the beneficial owners and asset managers of index tracking funds, as some of the existing challenges with new emerging markets such as China revolve around how ‘trackers’ can ensure that they deliver performance as close as possible to the index return.
As far as MSCI is concerned, they have just completed a recent round of global consultations with international investors and will announce the results on 20 June. The question was clear: have the Chinese authorities made enough progress on making Chinese equities accessible and investable for international investors?
The debate has now distilled down to three important areas of improvements made to date, by both the Chinese domestic equity market and those being proposed by MSCI:
- The removal of the monthly repatriation cap of 20 per cent for Qualified Foreign Institutional Investors, known as QFIIs, which was restrictive for international investors;
- The effective implementation of the new trading suspension treatment, mitigating risks around dealing in stocks that were often suspended in the past;
- The removal of anti-competitive measures that restrict the introduction of products linked to China A-shares.
At this stage, the proposition from MSCI is to include China A-shares in the MSCI Emerging Markets Index with a weighting of around 0.50 per cent, which equates to approximately a 5 per cent inclusion factor, restricting the investment universe of investable China A-share companies from an estimated 448 to 169 stocks. Although this may seem like a small step in comparison with the current weighting of 27.67 per cent of offshore Chinese shares, it is in fact very significant, for two reasons:
Accessing the world’s second largest economy
First, the measures taken by the Chinese authorities should allay investors’ concerns around quotas, suspensions, and the ability to manage a fund tracking an index which includes A-shares. The restrictions and rules proposed by MSCI complement this by limiting the investment universe to the highest-quality and most liquid shares, which many see as an acceptable compromise. It can therefore be a first step in accessing China’s onshore equity market in a reassuring and controlled manner, before moving on to bigger and better things.
As a matter of fact, while the importance of China’s economy is common knowledge, what is much less well-known is that the country’s equity markets are also among the world’s largest. More broadly, China is set to be a key player in the global economy’s shift in focus from West to East. There is some controversy around this as not everyone believes in the “Asian Century”, but for those who think China will continue to be an increasingly important player, it stands to reason that its financial markets should provide valuable opportunities in the coming years. Similarly, the major index providers should be keen to represent this economic reality through their indices.
We also believe that, although it is unlikely to lead to meaningful capital inflows in the near term, the renminbi’s inclusion in the IMF’s SDR basket last October should have a significant positive impact on structural capital inflows over the long term, serving as a catalyst for the acceleration of financial-market reform and liberalisation.
Diversifying investment portfolios
Second, investing in onshore Chinese equities delivers diversification benefits, particularly when it comes to shares listed on the Shenzhen stock exchange. Two years after Shanghai, the Chinese authorities and the regulator in Hong Kong launched the Shenzhen-Hong Kong Stock Connect (SZ-HK), in August 2016. This is very significant for international investors, because the SZ-HK has a combined market capitalisation of $10bn, second only to the US stock market.
The trading link provides a low-cost conduit for RQFIIs, including ETFs, to gain direct access to A-shares, as it does not require a license or quota. What is very attractive to investors is the wider selection of stocks with characteristics of technology, high-growth and small-to-medium enterprises, so called ‘new economy’ stocks as opposed to blue-chips listed on the Shanghai stock exchange. Shenzhen is home to many Chinese internet, advanced technology and software start-ups. The link opens up the Shenzhen stock exchange to global investors, and also provides Chinese investors with greater access to Hong Kong, its reciprocal.
China is very much part of HSBC’s DNA, and we believe the recent changes in accessing mainland China via the Stock Connect programmes are significant. Subsequently, we think the changes being considered by the major indices are exciting too. We hope that one day China will be part of the standard MSCI & FTSE indices so investors can gain that access, especially as passive becomes a larger portion of global equity allocations.
Joseph Molloy is head of passive equities and quantitative equity strategies at HSBC Global Asset Management