China’s A shares will be much sought-after internationally with their planned addition to key global indices next year
Worth more than the markets of London or Frankfurt, China’s two key stock markets in Shanghai and Shenzhen are an increasingly important source of capital and a strategic play for global investors.
As of Aug 31, the Shanghai stock market had a capitalization of 32.73 trillion yuan (US$4.95 trillion) while the main market in Shenzhen accounted for another 23.33 trillion yuan. Their combined market cap puts China roughly on par with the Tokyo Stock Exchange and the New York-based Nasdaq, trailing only the New York Stock Exchange, which is four times larger.
China’s domestic equities market is the second-largest in the world in terms of market capitalization and trading value.
The value of the Shanghai market today is almost three times the 13.3 trillion yuan it was worth in April 2009. The Shenzhen market has grown just as fast. It was worth just 6.9 trillion yuan in August 2012.
With all that capital at play, China’s stock markets are increasingly influential in global investment portfolios.
On June 20, major equity indices provider Morgan Stanley Capital International (MSCI) announced a plan to include China A shares in its Emerging Markets Index — tracked by funds with a combined US$1.5 trillion in assets under management — and its All Country World Index. After years of debate, this inclusion is planned to take place in two stages starting next May and is widely seen as a boon for the China stock market.
“With the inclusion, global passive funds will be obliged to invest (in the) China A-share market, while international investors seeking a truly diversified global asset allocation can be expected to include domestic China in their portfolios,” said Eugene Qian, chairman of the China strategy board at investment bank UBS.
The inclusion is a long time coming and underscores the growth of Chinese markets. It will bring billions of dollars from passive funds that are linked to the indices as well as the possibility of other international investors buying A shares. UBS expects more than US$14 billion in new capital will flow into the A-share market after the inclusion, and that is just the beginning.
MSCI said the decision was based on the “broad support from international institutional investors”. Key to this support was the market access facilitated by the two Stock Connect programs that link the Hong Kong bourse to those in Shanghai and Shenzhen, as well as the loosening of pre-approval requirements.
MSCI plans to first add 222 China A large-cap stocks, or 5 percent of the A-share universe, to its Emerging Markets Index, representing a 0.73 percent weighting. These include some of the biggest Chinese company names, such as Industrial and Commercial Bank of China, PetroChina and Ping An Insurance.
MSCI will implement the 5 percent partial inclusion in two steps — during its May 2018 semi-annual index review and August 2018 quarterly review. However, should the 13 billion yuan daily limits on the Stock Connect programs be eliminated or significantly expanded, MSCI will consider a one-step inclusion.
In the longer term, if China continues to open its financial markets, a possible full inclusion would raise China’s proportion of the Emerging Markets Index to about 40 percent of the total and could bring US$300 billion in fund inflows, according to UBS.
This could take some time. It took other emerging markets, such as South Korea, between six years and a decade to be fully included.
Over the past two years, Chinese regulators have implemented measures to align the regulations governing the A-share market with global standards. The Shenzhen-Hong Kong Stock Connect has completed access to about three-fourths of the large and mid-cap companies in the A-share universe.
Also, quota limits on mutual market access for the Shanghai-Hong Kong Stock Connect were abolished in August 2016. Revised trading suspension rules were also set last year to reduce the number of companies under long-term suspension.
Despite the forward movement, professional investors do not expect the impact to be immediate.
“With more institutional investors from the West, the Asian market can become less retail-driven,” said Kenny Wen, wealth management strategist at Sun Hung Kai Financial. “But the short-term impact will be very limited.”
Wen said the next opening-up measures the Chinese regulators might take could be to remove the Stock Connect daily trading limits and include other investment instruments.
An investor looks at stock information at a brokerage in Shanghai on March 16. Morgan Stanley Capital International plans to include China A shares in its Emerging Markets Index and All Country World Index starting next year. (AFP)
Concerns and challenges
While the accessibility of China’s stock markets is improving, and index tracker funds will have little choice but to follow the index weightings, there is still debate as to whether foreign investors will flock in. Though they are closely observing and looking for the right opportunity to enter the market, they also have major concerns.
“One of the challenges of assessing foreign investors’ interest in A shares is that globally there are many different types of institutional investors, all with different risk-return preferences and different views on China,” said Qi Wang, founder and CEO at MegaTrust Investment (HK). “It is rather difficult to generalize.”
MegaTrust just launched an offshore fund that aims to help potential overseas investors with its local market expertise.
“Looking from a macro perspective, the Chinese financial markets are still troubled with issues like shadow banking, bad debt and other sources of systemic risks, which the regulators are trying to prevent by tightening policies,” said Wang.
“The A-share markets are not completely out of the woods yet.”
Wang told China Daily Asia Weekly that many foreign investors still lack confidence in Chinese markets, but their views are getting more and more positive, especially after the market trough in early 2016. “The darkest hour has likely passed,” he said.
The A shares selected for MSCI’s index inclusion come primarily from the consumer and finance sectors, and have good sustainable earnings growth visibility.
“Foreign investors are more likely to be interested in listed companies in the banking and consumer goods sectors, because these companies have more comparables overseas and are relatively easy to understand,” Wang said.
“Big caps are also on foreigners’ radar screens since they are more stable, able to generate cash earnings, have better disclosure and corporate governance and so on.”
Thomas Fang, head of China equities at UBS, said: “There is already tremendous demand from our clients to invest in China’s domestic market.”
But, despite the fact that foreign investors are warming to A shares, China still has a long way to go to integrate with the global markets.
For example, while domestic retail investors are very sensitive to local policies and stock prices, global investors are more concerned about price-earnings ratios and companies’ fundamentals.
Also, Chinese companies’ high credit ratings with the domestic rating system are less convincing globally when compared to those of agencies such as Standard & Poor’s, Fitch Ratings and Moody’s.
“About 80 percent of the Stock Connect daily trading quota is currently occupied by local retail investors,” said Wen at Sun Hung Kai.
“Global institutional investors are participating very little compared with the Hong Kong market, so there’s still a long way to go (to catch up on global investment).”
Stephen Tu, vice-president and senior analyst, global financial institutions, at Moody’s Investors Service, said: “We do not expect large inflows of foreign capital into China in the near term, because of foreign exchange issues — foreign asset managers take time to pick up on the learning curve and market familiarity; and disclosure issues — a lot of company disclosures are in Chinese.”
Tu expects the long-term effects to be positive. “A gradual increase of foreign participation in the onshore market … will encourage market development toward a global standard.”
China still has to tackle challenges, such as transparency and disclosure issues, currency convertibility, and corporate governance that aligns better with international accessibility standards, he added.
Just one month after the inclusion announcement, Chin-Ping Chia, MSCI’s head of research for Asia Pacific, told Reuters that if MSCI finds a Chinese company has been suspended from trading for more than 50 days, it will remove it from the index and not bring it back for at least 12 months. This rule would apply only to Chinese companies. Stocks in other markets are up for re-inclusion consideration as soon as they resume trading after a long pause.
The MSCI inclusion is significant not only in that it will pave the way for global capital inflows into China’s A shares; it also means that China needs to tighten related regulations, improve corporate governance and increase the market’s transparency to reassure foreign investors.
“This is not just a simple inclusion of A shares,” said MegaTrust’s Wang. “We see it more as the globalization of China A shares similar to the globalization of the yuan.
“This globalization trend has just begun, and regardless of how fast A shares can be included in global indices, the underlying trend of China’s stock market internationalization will only become stronger.”