Fifty Shades of “A”

Can the MSCI Inclusion of China A-shares Be Trusted By Institutional Investors?

On June 1, after four years of intense consultations with institutional investors, MSCI will officially include yuan-denominated Chinese stocks, known as China A-shares, to the MSCI Emerging Markets Index and the MSCI All Country World Index (the official announcement date is May 14). This date is seminal because it recognizes and rewards China’s gradual market liberalization efforts to further open its domestic equity market to global investors. While some investors are still haunted by memories of China’s 2015 stock market crash, a deeper fear of missing out is expected to boost overseas investments in Chinese mainland stocks.

The Tipping Point: Stock Connect

In 2013, MSCI put-China A shares on a review list but declined to include them in any indices, citing issues related to capital mobility restrictions and uncertainties around taxes. Then in 2014, China raised the foreign ownership limit from 20% to 30% and launched the Shanghai Stock Connect program. The Stock Connect link allowed mainland Chinese investors to purchase select Hong Kong and Chinese companies listed in Hong Kong, and let foreigners buy China-A shares listed on the mainland’s largest stock exchange in a less restrictive manner.

In 2016, in attestation to the integration of China’s financial markets into international finance, the International Monetary Fund (IMF) added the renminbi (RMB) to its special drawing rights (SDR) basket of currencies.[1] Later that year, China’s continued commitment to market liberalization resulted in the creation of the Shenzen Stock Connect. The convergence of two Stock Connect programs created a single “China stock market” that ranks as one of the biggest in the world by both market cap and daily trading turnover.

In a June 2017 press release announcing the inclusion of China A-shares, Remi Briand, MSCI Managing Director and Chairman of the MSCI Index Policy Committee said, “International investors have embraced the positive changes in the accessibility of the China A-shares market over the last few years and now all conditions are set for MSCI to proceed with the first step of the inclusion. The expansion of Stock Connect has been a game changer for the market opening of China A-shares.”[2]

Implementation: The MSCI Two-Step

The first step of the inclusion, effective June 1, will see 222 large-cap China A-shares added with an Index Inclusion Factor of 2.5% of their market capitalization in the MSCI China Index. This represents a weight of approximately 0.37% in the pro forma MSCI EM Index. The second phase, expected to be effective September 3, increases the Index Inclusion Factor to 5% and the weight of the China A-shares to 0.74% of the pro forma MSCI EM Index and 0.1% of the MSCI AWCI.[3]

With an expected $17 billion expected to flow into mainland bourses, there has been concern among global investors that money flows from Hong Kong into China via the stock connect scheme around the time of the MSCI inclusion may breach the daily quota, as passive index funds need to buy the new A-share constituents to avoid tracking error. However, effective May 1, the Chinese Securities Regulatory Commission, in partnership with the Securities and Futures Commission of Hong Kong, quadrupled the daily transaction limit from 13 billion yuan ($2 billion) to 52 billion yuan, while that for the Shenzhen-Honk Kong Stock Connect quadrupled to $42 billion yuan.[4]

The Coming China “A” Tsunami

Given the actual size of China’s economy and domestic stock market, the June and September inclusions are relative drops in the bucket. For example, if the Index Inclusion Factor of the 222 large cap stocks were raised to a fire hose level of 100% versus from the water pitcher sprinklings of June’s 2.5% and September’s 5%, levels, China’s pro forma weighting of the MSCI EM Index would approximate 13%.[5]

Reaching full inclusion will take a great deal of time and is likely far off in the future. To provide some historical context about how quickly China’s weight in global benchmarks could increase, consider Taiwan and South Korea. Taiwanese equities took nine years (1996-2005) to achieve full inclusion, and South Korean equities took six years (1992-1998). China is starting with a much lower inclusion factor of 2.5% (versus 20% for South Korea and 50% for Taiwan), so it could take at least a decade for full inclusion to be achieved.[6]

According to MSCI, further inclusion of China A-shares will be subject to greater alignment with international market accessibility standards, the resilience of Stock Connect, the relaxation of daily trading limits, continued progress on trading suspensions, and further loosening of restrictions on the creation of index-linked investment vehicles.

What About China Mid-Caps?

Beyond raising the index inclusion factor that can easily increase China ‘A’ shares’ weight in the MSCI Emerging Markets Index by 20 times, the possible addition of mid-cap stocks will be an imminent next step on the index provider’s future inclusion roadmap. This will quickly double the number of stocks being included in the EM index.

MSCI currently has a China ‘A’ International Index consisting of 459 stocks, 195 of which are mid-cap stocks. Using the index provider’s stringent criteria, these mid-cap stocks which, have a full company market cap of $1.0tn, can be whittled down to $280bn in ‘foreign inclusion factor-adjusted’ market cap. Assuming that these 195 mid-cap ‘A’ shares are added to the MSCI Emerging Markets Index, this will enlarge the universe from 222 large-cap stocks to 417 stocks. Correspondingly, with 100% index inclusion (instead of MSCI’s current 5% IIF), the adjusted market cap will rise from $697bn for the large-caps only to a total of $977bn (including mid-caps).[7]

Conclusions

Exclusive of the inclusion of mid-cap stocks, China has the potential to grow its included market cap in the MSCI from $699 billion to $6.4 trillion.[8] Two scenarios factor into this assumption:

  • China’s sheer size
  • Its command economy that can see things decided and implanted quickly

China’s inclusion in MSCI’s EM and World indices are a harbinger of the vast investment opportunities available in a country that for decades was largely ignored by institutional investors. China’s efforts towards market liberalization, paired with MCSI’s ongoing seal of approval, should provide comfort for global asset managers to recalibrate their China exposures and strategy to take advantage of these trends.

[1] “MSCI Inclusion of Domestic ‘A’ Shares in China’s Grand Entrance onto World Stage,” Nikko Asset Management, Feb. 5, 2018.

[2] “MSCI to include China A shares in EM and ACWI indices,” ETF Strategy, June 21, 2017.

[3] “Inclusion of China-A shares in the MSCI Emerging Markets Index,” State Street Global Advisors, Sept. 2017.

[4] “Limits on links to quadruple,” Chinadaily.com, April 23, 2018

[5] “Inclusion of China-A shares in the MSCI Emerging Markets Index,” State Street Global Advisors, Sept. 2017.

[6]China A-Shares: Include Them In Your Portfolio Now,” Seekingalpha.com, May 1, 2018.

[7] “MSCI Inclusion of “A” Shares is China’s Great Leap Onto World Stage,” ETF Strategy, January 30, 2018

[8] “MSCI Inclusion of Domestic ‘A’ Shares in China’s Grand Entrance onto World Stage,” Nikko Asset Management, Feb. 5, 2018.

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