Why MSCI’s inclusion of A shares should be a clarion call to foreign investors
Aidan Yao says although it may take years for the inclusion of A shares in the MSCI index to generate significant foreign capital inflows, the move is still worthwhile
The internationalisation of China’s equity market is about to receive a major symbolic boost as the Morgan Stanley Capital Index (MSCI) will soon add A shares to its index universe. This is a milestone in the integration of Chinese equities into the world market that will put A shares on global investors’ radar.
Capital inflows to the onshore equity market, via the Stock Connects, have already picked up in recent weeks, despite the Sino-US trade tensions and rising economic headwinds. Nevertheless, the MSCI entry might not create an immediate liquidity windfall large enough to change onshore market dynamics.
The primary reason is the limited inclusion at the start. The MSCI will add only 2.5 per cent of the 234 stocks eligible for inclusion on June 1, which will be raised to 5 per cent on September 3. Once completed, A shares will account for 0.8 per cent of the MSCI Emerging Market (EM) index and around 0.1 per cent of the MSCI World index.
These inclusions could generate around US$18 billion of foreign capital inflows to the onshore market, which is a drop in the ocean of the US$3.4 trillion (free-float market capitalisation) behemoth, with a daily trading volume of around US$75 billion. However, as the inclusion factor increases over time, the size of capital inflows will grow accordingly.
Once fully incorporated, it is estimated that China’s A shares will account for 17 per cent of the MSCI EM index, and together with the offshore listed stocks, such as H shares, Chinese equities overall could make up over 40 per cent of the index.
That will not happen overnight. Both Korea and Taiwan went through a lengthy process in the 1990s – taking them six and nine years respectively – to have their markets fully incorporated into the MSCI.
Notwithstanding the long road ahead, efforts to integrate A shares into the world are worthwhile for a number of reasons.
First, the inflow of foreign institutional money can help reduce the speculative nature of the Chinese market by balancing the short-term, retail flows (86 per cent of the current market turnover) with long-term, institutional flows. Such a shift in the investor composition can change the investment style of the market from speculative and theme-driven investing to value-and-fundamental-based investing.
Second, increased foreign inflows can deepen liquidity and improve the price discovery of the market. Relative valuations of different market segments – large versus small caps and growth versus value stocks – may undergo profound shifts as investor preference changes.
Finally, increased foreign investor participation can put pressure on Chinese regulators to improve market infrastructure, and force listed companies to align their practice of information disclosure, business transparency and corporate governance to global standards.
For international investors, the Chinese market is getting hard to ignore, given its size and influence. Last year’s 52 per cent surge in the MSCI China index has put Chinese equities back on the map. With the macro environment having stabilised and Beijing continuing to reform, the MSCI inclusion could serve as an additional catalyst for global investors to gain A-share exposure.
Moreover, there are four “market-specific” reasons why adding A shares to a global equity portfolio makes sense. First, the size appeal: Chinese equities are the second-largest market in the world, with trading volume accounting for over 20 per cent of the global total in 2017.
Second, adding A shares to a global portfolio can lower aggregate volatility of returns, as movements of the Chinese market tend to be less correlated with others.
Third, foreign investors will be investing in A shares at a time when Chinese investors are also increasing equity allocation. Currently, real-estate assets account for 65 per cent of Chinese households’ portfolios, while equity represents only 3 per cent. This compares to a 49 per cent to 17 per cent split for an average US household’s portfolio. China appears to be on the cusp of an internal reallocation of assets from real estate to capital markets, similar to what the US has gone through since the 1960s.
Finally, the A-share market offers some unique exposures to the Chinese economy, which do not exist in offshore markets, such as new economy stocks which should benefit from China’s economic transformation.
Overall, the MSCI inclusion could mark a new trend in the liberalisation of China’s equity market. Provided that Beijing continues to reform the economy, there should be significant scope for foreign ownership of A shares to rise from its current level of only 2 per cent.
Aidan Yao is senior emerging Asia economist at AXA Investment Managers