Caroline Yu Maurer
Global index provider MSCI is set to quadruple the inclusion factor for China A-shares from 5% to 20% in three steps (see Exhibit 1):
1) May 2019: the inclusion factor for large caps rises from 5% to 10%; large cap stocks listed on the ChiNext market will be added with a 10% inclusion factor.
2) August 2019: The factor for all large caps rises to 15%.
3) November 2019: The factor for all large caps is increased to 20%; mid-caps will be added with a 20% factor.
These steps suggest that the pro-forma index weight of A-shares in the MSCI Emerging Market index (MSCI EM) will rise to 3.3% by November 2019 from the current 0.7%. As a result, the index will have 253 large and 168 mid-cap A-shares, including 27 ChiNext stocks. At the sector level, consumer staples, industrials and materials will have a higher weight in the MSCI China index, mostly offset by a reduction in the weight of information technology and communication services.
The latest MSCI decision has received overwhelming support from international institutional investors. The successful implementation of the initial 5% inclusion boosted investor confidence. Investors recently welcomed the following commitments by the Chinese authorities:
A further increase in the weight of A-shares beyond 20% would largely depend on the Chinese authorities addressing the remaining market accessibility problems such as access to hedging and derivatives, the short settlement cycle of China A-shares or trading holidays on Stock Connect.
From a longer-term perspective, improved foreign investor access should pave the way for the A-share weight to rise further. In the case of full inclusion, A-shares (together with the China H-shares and American depositary receipts already included in the MSCI EM index) should take the index weight of Chinese equities to around 40% (see Exhibit 2).
A move towards full inclusion would be a lengthy process. It took around nine years for Taiwan and six years for South Korea to move from initial partial inclusion to full inclusion. In both cases, the inclusion ratio was gradually raised until it reached 100%. Given the pressure from the Sino-US trade tensions and signals from the Chinese authorities regarding further reforms and the opening up of capital markets, we believe that full MSCI index inclusion may take place sooner than expected.
In our view, the large jump in the inclusion factor can boost the presence of foreign investors in the Chinese onshore equity market. According to the People’s Bank of China (PBoC), foreign investors held RMB 1.15 trillion (USD 171 billion) of A-shares as of December 2018. They accounted for 6.7% of the free-float market cap of the onshore market, thus almost trebling their presence from 2.3% in November 2015 (see Exhibit 4). Recent inflows into A-shares have been significant, with a record RMB 121 billion (USD 18 billion) via the northbound Stock Connect scheme in just the first two months of 2019 after RMB 294 billion in 2018 and RMB 199 billion in 2017.
Other catalysts have contributed to this rising foreign participation, including: 1) the doubling of the QFII quota to USD 300 billion; 2) the forthcoming combination of QFII and its RMB-denominated quota (RQFII); 3) broadening the investment scope to derivatives, bond repurchases and private funds; and 4) the addition by global index provider FTSE Russell of 5% of the free-float market capitalisation of A-shares to its emerging market indices due in June 2019.
Rising foreign participation should favour the increasing institutionalisation of the market. We believe this would be desirable given that the A-share market is now mostly retail-driven. In 2018, retail investors accounted for 35% of the total free-float market cap and 82% of daily turnover in 2017.
Our Greater China Equities investment team, managed by Lead Portfolio Manager Caroline Yu Maurer, generally favours Chinese market leaders that are competitive and unique. Northbound fund flows at the individual stock level suggest that foreign investors are mostly attracted to large-cap and more liquid stocks. Our team will particularly favour companies delivering sustainable and high-quality earnings growth at an attractive share price over the long term, benefiting from the following investment themes:
1. Technology & innovation: The Chinese economy has begun to shift from cheap, labour-based manufacturing towards medium to high-end manufacturing. We expect a rapid emergence of competitive firms in industrial automation, IT, capital goods, and the new industrial and consumer sectors.
2. Consumption upgrading: We see significant growth prospects for leading companies in healthcare, education and travel. A number of these domestic winners are supported by rising household income, low household debt and more diversified consumer profiles.
3. Industry consolidation: Consolidators in mature/excess-capacity industries are emerging as strong leaders both domestically and globally.
The expanding share of China A-shares in MSCI global indices should help to strengthen global interest in this market and trigger more foreign fund inflows into China. We expect the MSCI inclusion of A-shares to attract USD 400 billion of inflows over the next five to 10 years.
In our view, the latest news is about more than just a further opening by MSCI – wider inclusion in the indices is a sign of international recognition of China’s market liberalisation efforts. It should support President Xi Jinping’s ambitions to make the renminbi a global currency. The government recently highlighted that capital markets are an integral part of China's core competitiveness. It aims to deepen structural supply-side reforms in the financials sector and reinforce the sector's ability to serve the real economy.