MSCI's June announcement of its intention to include Chinese ‘A’-shares in its Emerging Markets Index as of summer 2018 marks another milestone in the progressive liberalization of China’s capital market. Inclusion will take place in two steps, with the addition of Chinese stocks in June and August of 2018, meaning that ‘A’-shares will represent 0.73% of the weight of the MSCI Emerging Markets Index at a 5% partial inclusion factor.
The liberalization of the Chinese stock market dates back to November 2002, with the introduction of the Qualified Foreign Institutional Investor (QFII) scheme, giving overseas investors quota-based access to the market. Quotas under the QFII initiative, which were originally set at $4 billion, have been progressively raised over the last 15 years, and by mid-2017 had reached in excess of $90 billion.
The QFII scheme has been complemented since 2011 by RMB QFII regulation (RQFII), which allows for the use of RMB funds raised in Hong Kong by the subsidiaries of domestic fund management companies to invest in the domestic securities market.
A more recent initiative aimed at building on the “softly, softly” approach to capital market liberalization in China has been the “Stock Connect” links between the exchanges on the mainland and the Hong Kong Stock Exchange (HKSE). Beginning in Shanghai in November 2014 and extended to Shenzhen in late 2016, this initiative aims to create a single Chinese stock market by allowing investors based on the mainland to buy a selection of Hong Kong and Chinese shares listed on the HKSE. At the same time, it reduces the restrictions previously placed on foreign purchases of Shanghai and Shenzhen-listed companies, adding more than 1,400 companies to overseas institutions’ investable universe.
Implications for investors
“The inclusion of Chinese onshore shares in the MSCI benchmark has several highly significant implications for global emerging market investors,” says Ivan Seah, Head of APAC Capital Markets Product Specialists, S&P Global Market Intelligence.
First among these, the addition of 222 ‘A’-shares to the index will make the component of Chinese shares accessible to international investors more representative of China’s economy, which is still one of the fastest-growing in the world. China accounts for about 15% of global GDP, but shares accessible to overseas investors – largely through those listed in Hong Kong and the US – have not generally been accurate proxies for the Chinese economy.
Second, China’s inclusion in the MSCI index will turbocharge an inflow of funds into the Chinese market from international investors. MSCI itself has said that $17 to $18 billion of indexed money is likely to flow into the market initially. Some analysts have estimated that these inflows will be even higher over the next five to 10 years. This will have far-reaching implications for liquidity, valuations, and governance as international investors progressively increase their allocations to Chinese equities. Today, holdings among overseas investors account for less than 1.5% of China’s total market capitalization.
Rising overseas participation will have a significant impact because it will increase institutional ownership of quoted stocks on the Shanghai and Shenzhen exchanges (SHSE and SZSE). These have historically been retail-driven markets with relatively modest free floats of below 50%. The predominance of retail investors in the Chinese equity market has meant that while trading volumes have been higher than in markets such as Hong Kong and Taiwan, they remain dwarfed by those in the U.S.Evidence from developed markets such as Hong Kong and Australia indicates that as equity markets expand, and as more companies are listed and free-float levels rise, coverage by equity analysts increases markedly. This in turn implies that equity valuations become more reflective of fundamentals.
Empirical evidence suggests that each of the major initiatives that China has taken to open its capital market to international investors has pushed trading volumes and valuations up across most sectors. “Considering the aggregate size of market liberalization policies only represent a small percentage of A-share market capitalization, the momentum of market movement around these event occurrences, on average 4.5% within 30 days, indicate a strong behavioral effect within domestic retail investors,” says Seah. This is supported by the performance of stocks excluded from each stock connect implementation seeing similar positive performance as those that were included. Most dramatically, according to S&P Global Market Intelligence data, in the two weeks following the Shanghai Stock Connect, both the Shenzhen and Shanghai markets saw growth of around 8%, although no Shenzhen stocks were available through the scheme.
Additionally, adds Seah, “in the period after RQFII implementation, small-cap companies outperformed large-caps on average by over 2% each month, which may reflect domestic retail investors’ preference for cheaply priced stocks, independent of financials.”
Growing influence of factor-based investment in China
A third notable by-product of the continued opening-up of China’s equity market to overseas investors is that it will underpin a greater focus on rules-based, factor-driven investment strategies among both international and domestic investors. Factor-based investment has grown in popularity in recent years as it is perceived to provide enhanced diversification, transparency, and risk-adjusted returns at a lower cost than many other investment strategies.
Further evidence of the rising influence of factor-based investment in the Chinese equity market has been observed since the implementation of the Stock Connect programs, according to S&P Market Intelligence data. Following the launch of the Shanghai Stock Connect scheme in 2014, there was a notable emphasis on so-called “old economy” sectors, while in the slipstream of the new Shenzhen Stock Connect regime, quality factors such as valuation, historical growth, and earnings quality have all assumed greater importance. Large caps also picked up momentum following the launch of the Shenzhen Stock Connect project, signally rising inflows of institutional capital.
“The opening of Chinese equity markets, which is already the second largest equity market in the world, is a historical milestone representing a unique investment opportunity,” says Seah. “For those able to accept the risk, this is a scenario where all indicators point to a market evolving towards more institutional investment strategies, together with the promise of capital inflow triggered by MSCI index inclusion.”