From the media coverage, you would think it was the most important event to happen all year. From next month, 234 shares listed on China’s onshore stock markets are to be added to the emerging markets benchmark compiled by international index company MSCI.
“US$400 billion expected to flow into Chinese stocks after MSCI inclusion” proclaimed a breathless headline in our very own South China Morning Post, quoting a “top fund manager”.
Now, US$400 billion is a lot of money by anyone’s standards. It’s roughly the capitalisation of Singapore’s entire Straits Times index. If that amount of additional cash were really about to flow into China’s domestic stock markets, it would be big news indeed.
Unfortunately, it’s time for a reality check.
Firstly, it’s worth noting that the shares of Chinese companies have been included in MSCI’s emerging markets index for years. Until now however, the index compiler has only selected shares listed in Hong Kong or on US exchanges.
Poor governance and regulatory standards and the difficulty of repatriating funds kept A shares – domestic shares of mainland companies denominated and traded in yuan by mainland residents – out of the widely followed benchmark.
Over the past couple of years, regulatory reforms have resolved many of those problems. So MSCI has finally decided to include A shares for the first time. But the company is moving cautiously.
It has selected a list of 234 large-capitalisation stocks for inclusion. If they were to be included at their full market capitalisation of around US$5 billion, they would double the value of the MSCI emerging markets index.
But they are not going into the index at anything like the weighting their size would suggest. First, the free float – those shares available for investment by the general public – of Chinese companies is relatively small, with the state retaining a controlling shareholding in many large companies.
Then the Chinese regulators impose a foreign ownership limit on domestic shares equal to 30 per cent of that free float. Finally, MSCI is proposing an initial “inclusion factor” of 2.5 per cent of the foreign-investible float, rising to 5 per cent in September.
As a result, the initial weighting of Chinese A shares in the MSCI emerging markets benchmark will be just 0.39 per cent, rising to 0.78 per cent. With investment portfolios worth US$1.9 trillion from all over the world benchmarked to the MSCI emerging markets index, that implies investment managers will allocate US$7.4 billion to A shares as a direct result of their inclusion in the MSCI index next month, rising to US$14.8 billion after September. Clearly, US$14.8 billion is a far cry from the US$400 billion our “top fund manager” is expecting to flow into A shares.
Yes, as China’s domestic markets develop over the next 10 years or so, MSCI is expected to raise its inclusion factor to more than the initial 5 per cent level. But even at 100 per cent, on current prices the allocation to A shares would only be US$300 billion, not the claimed US$400 billion.
And that is a very long-term prospect. Although the Taiwanese market was investible to foreigners from the early 1990s, it was not until 2005 that MSCI raised the island’s inclusion factor to 100 per cent.
In the short term, the likelihood is that not even as much as the implied US$14.8 billion will flow into the A-share market as a direct result of its inclusion.
That’s because the MSCI emerging markets index is a vast construction, comprising close to 1,000 constituent stocks. Very few portfolio managers want to own that many shares; it’s too expensive. As a result, even those who aim to track the index closely tend to hold just a few dozen, or perhaps as many as 100, of the biggest constituents, in proportions carefully calculated to replicate the overall benchmark’s performance.
With China’s onshore market weighted at just 0.78 per cent of the index, few of these managers will bother buying A shares. Why should they? The effect of A shares on the index’s performance will be negligible compared with, say, Hong Kong-listed Tencent, which has a weighting in the index of 5.2 per cent.
The conclusion is that anyone buying into A shares today through the Hong Kong stock exchange’s “Connect” scheme in the expectation of vast inflows to come following MSCI inclusion in June is likely to be sadly disappointed.
At most, the inflows this year as a direct consequence of inclusion are likely to be no more than US$14.8 billion, probably much less. Either way, they will be insignificant compared with the US$100 billion monthly turnover on mainland exchanges, and will have no discernible impact on share prices.
That doesn’t mean investors should dismiss A shares out of hand. There are some good reasons to look closely at China’s onshore market. A shares are cheaper than stocks in other markets, including their counterparts listed in Hong Kong. And with China entering a cycle of monetary easing and economic activity robust, profit growth is strong. Moreover, since the authorities made new issues easier, more private sector companies in attractive business sectors are listing on mainland exchanges.
But investors should also be aware of the risks. Chinese domestic markets may not be quite the casinos they were a few years ago, but governance is poor, insider trading rampant, and protracted stock suspensions the norm. And the regulators trigger periodic panics with their ham-fisted imposition of new trading rules.
So investors should approach the A-share market with open eyes. And they certainly shouldn’t buy in response to ludicrous forecasts of massive inflows as a result of the market’s inclusion in MSCI’s index. It’s really no big deal. ■
Tom Holland is a former SCMP staffer who has been writing about Asian affairs for more than 20 years