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China stock market

Why a rally may be round the corner for Chinese stocks

PUBLISHED : Monday, 02 May, 2016, 2:35pm
UPDATED : Monday, 02 May, 2016, 2:35pm

This June could be huge for Chinese stocks as global stock index provider MSCI decides whether to include A shares in its benchmarks. Some fund managers and analysts say the answer might be a yes, and a lot of money may be moved into China as a result.

MSCI recently reopened talks to admit yuan-denominated A shares, both Shanghai- and Shenzhen-listed, into its influential MSCI Emerging Markets Index that is tracked by approximately US$1.5 trillion in assets worldwide. The index provider will announce the decision in June amid its annual index review, after two previous proposals since 2014.

“I would say a yes (on the inclusion in June),” said Elvin Yu, head of international sales and client relationships at ICBC Credit Suisse Asset Management. “While there are a number of issues to resolve, the implementation would be in 2017, hence there’s another year to nail down these outstanding issues.”

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He added the unaddressed matters include the opaque suspension mechanism, repatriation of funds, and the anti-competitive clause that restricts investors’ access to derived information.

Last June, MSCI said it delayed the addition of A-shares in the benchmark mainly due to international investors’ worries on China’s restricted market access and lack of transparency.

Since then, however, Chinese markets have opened up further. Premier Li Keqiang said in March at the Boao Forum that the government was working to launch the Shenzhen-Hong Kong stock connect this year. The scheme will allow foreign retail investors to directly buy Shenzhen’s smaller-cap equities for the first time. In November 2014, China opened up its Shanghai-listed shares to foreign investors through the landmark Hong Kong-Shanghai Stock Connect programme.

“We feel that there is a higher probability that A-share inclusion could happen this year,” said Ken Wong, Asia equity portfolio specialist at Eastspring Investments.

He said MSCI had expressed key concerns in its last review on China’s lack of transparency on the quota system of QFII (Qualified Foreign Institutional Investor) and the ability for fund managers to repatriate capital out of China.

Nevertheless, those issues have been “somewhat resolved”, he said.

The State Administration of Foreign Exchange, China’s foreign exchange regulator, announced in early February that fund managers were no longer required to apply for investment quotas in the QFII system, but instead can operate a new scheme linked to the size of assets under management. The ceiling of the new quota has increased to US$5 billion, compared with US$1 billion previously.

Besides, QFII funds would be able to pull funds out of China after three months, instead of the previous one-year rule.

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In addition, as China has opened up its inter-bond market without the need for RQFII (RMB Qualified Foreign Institutional Investor) quota, it should free up more QFII quota for A shares, which should further resolve the issue of limited market access to international investors, Wong added.

“One can see that mainland authorities have shown great commitment to further reform and open up the capital markets,” said Sally Wong, CEO of Hong Kong Investment Funds Association.

She agreed further relaxation of the QFII regime in February would have a favourable impact.

There are also a number of other positive factors, including the China Securities Regulatory Commission’s clarification on beneficial ownership last May, the pending Shenzhen stock connect, the refinement of the Shanghai stock connect scheme, as well as the implementation of the mutual recognition of Hong Kong funds and their Chinese peers.

If A shares join the MSCI club in June, it may ignite a rally in Chinese stocks even though it will actually be implemented only after a year and initial capital flows may be limited, according to market insiders.

“This could create a positive sentiment in the China market,” Yu said. “I wouldn’t be surprised if some investors take this opportunity to get ahead, hence there is a chance to see liquidity flowing into the China market.”

The possible weighting of A shares in MSCI’s benchmarks are not known yet and some analysts expect only 5 per cent, which would mean limited initial capital flows into A shares, said Ken Wong from Eastspring Investments. Still, investors can expect an initial boost to the A-share markets in the short term, Wong added.

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UBS analysts also believe the probability of the inclusion is much higher this year. Although initial flows to individual stocks would likely be limited, the long-term positive implication will be more far-reaching than the short-term benefits of potential capital inflows.

“Assuming a 2017 inclusion at a 5 per cent inclusion factor, A shares could have an initial weighting of

4 per cent in the MSCI China Index and 1.1 per cent in the Emerging Market Index, according to

MSCI. We expect c. (approximately) US$2.2 billion of inflows from passive funds in this scenario,”they said in a recent note.

The inclusion would benefit Shenzhen stocks more than their Shanghai counterparts as there are more stocks in Shenzhen representing the new growth engine of the Chinese economy, believe Societe Generale analysts.

“A decision to include mainland shares in MSCI international indices would indeed mean that the probability of launching Shenzhen connect shortly has increased. That would be an added benefit for this market (relatively to Shanghai) as it is more exposed to China’s growth sectors,” Societe Generale analysts said in a note, adding that their prescribed sector strategy is to lean towards consumer-related sectors rather than those more directly exposed to “the manufacturing recession”.