China’s A-shares bid for MSCI inclusion
- For the fourth year in a row, ratings agency, MSCI will debate whether or not to include China's A shares into their global equity indices
- While the timing for each of the previous bids for inclusion have been unfavourable, 2017 represents the country's best shot yet at inclusion.
- For Beijing, having Chinese equities in a recognised global index is of symbolic importance, but markets understand such an event, by itself does not guarantee large capital inflows immediately.
Index provider MSCI will debate whether or not to include China’s A-shares in their global equity indices at its Annual Market Classification Review on 20 June. This will be the fourth year in a row that the debate has been held and, in our view, represents China A-shares’ best chance so far of joining the indices. If a positive verdict is delivered, the implementation should start a year later.
Exhibit 1: China A-shares amongst the largest equity markets globally
Source: MSCI, Datastream and AXA IM Research
Fundamentally, the factors supporting the A-shares’ inclusion are clear. A-shares are the second largest equity market in the world by market cap and turnover. Even when measured using MSCI indices, the market capitalisation of the MSCI A-shares index is the fourth largest globally, worth US$1.7tn (Exhibit 1), despite only capturing a subset of the market, with 862 stocks. However, A-shares, akin to RMB bonds, are unrepresented in MSCI’s major global benchmarks. Even though Hong Kong and foreign-listed Chinese stocks are included, the weights are well below the relative size of China in the global economy and equity market.
Exhibit 2: Stabilisation in the China A-shares market
Source: Bloomberg and AXA IM Research
The timing for each of the previous bids for MSCI inclusion has also been unfavourable. Given their inaccessibility to foreign investors, A-shares did not stand much chance when MSCI first considered their inclusion in 2014. 2015 was a rollercoaster year for A-shares, when the market crashed almost 50% and volatility spiked to near-record highs. Similarly, last year, many investors had concerns about the Chinese economy, with wide-spread stock trading suspensions fuelling those worries.
Reversing the troubling conditions of 2015 and 2016, more favourable trends have emerged so far this year, with market valuations returning to reasonable levels and volatility normalising (Exhibit 2). In addition, Beijing has also made significant progress in clearing the hurdles that prevented A-shares’ inclusion in the past. Last year, MSCI raised three issues as reasons for its rejection of A-shares*, namely: restrictions on investment flows (e.g. difficulties and delays facing investors in applying QFII** quota, and capital repatriation being subject to a 20% AUM*** limit); trading suspension rules (Chinese listed companies can voluntarily suspend their stocks in order to avoid market selloffs); and anti-competitive clauses (e.g. onshore exchanges require pre-approval of investment products linked to A-shares, even if they are listed outside of China).
On capital restrictions, compared to the QFII and RQFII frameworks, the Hong Kong-Shanghai and Hong Kong-Shenzhen Stock Connect programmes have considerably enhanced foreign investors’ access to A-shares. MSCI this year has also proposed to narrow the universe of stocks for inclusion by focusing on only those available to the connect programs. This should help to significantly increase market accessibility. With respect to trading suspensions, the number of stocks on trading halts has declined significantly and is now back at pre-crisis levels after market stabilisation and the implementation of new suspension policies. Added to this, within the narrower set of only large-cap stocks, now being considered for inclusion, there are only two whose shares are currently suspended.
That leaves only the pre-approval requirement hurdle to clear. Discussions between MSCI and the onshore exchanges are currently taking place on this issue, but it looks unlikely that a breakthrough will be made before the announcement. This means that the inclusion decision will largely come down to how the anti-competitive clause is being assessed among other criteria. We assign a greater-than-even chance that MSCI will decide in favour of inclusion on 20 June, but do acknowledge the risk of another failure if MSCI is unwilling to compromise.
Exhibit 3: Stabilising profit margins and improving debt affordability
Source: Datastream and AXA IM Research
For Beijing, having Chinese equities in a recognised global index is of symbolic importance to its capital market liberalisation, similar to the RMB’s inclusion in the special drawing rights (SDR) basket. But for the equity market, such an event, by itself, does not necessarily guarantee large capital inflows immediately, especially if investors lack confidence in Chinese equities. To this point, although corporate fundamentals have improved with stabilising profit margins and better debt affordability (Exhibit 3), investor positioning in China remains light and the market remains a consensus underweight among global emerging market funds.
Passive index trackers will, however, have to adjust their allocations in the event of A-shares’ inclusion. But because of the smaller universe, there will only be 169 stocks eligible compared to the original proposal of 448 (Exhibit 4). In addition, the inclusion will be phased in over a period of time, with an initial inclusion factor of 5%. This will increase China’s weight in the MSCI World/Emerging-Market/Asia-ex-Japan indices by 0.1%, 0.5% and 0.6% respectively with limited impact on country and sector weights. This reflects a minor change in the index composition as China’s offshore-listed stocks already makes up 28% of the emerging markets (EM) index and account for almost 40% of EM equity trading volume.
With approximately US$1.6tn (active and passive) AUM tracking the MSCI EM index, the 0.5% weight amounts to US$8bn of inflows into A-shares, or 0.8% of A-shares’ free-float market cap and 2.6% of typical daily trading turnover. We estimate the total passive exchange-traded fund (ETF) assets under management tracking various global, emerging markets and Asia-focused benchmarks with a China component to be around US$348bn. The initial flows from global passive ETFs tracking various MSCI indices would lead to inflows to the tune of US$1.6bn into the China A-share market.
It is perhaps because of the expectation of a relatively minor impact on markets that Chinese investors have taken a more circumspect view towards the index inclusion this year. While a positive decision on 20 June will undoubtedly generate an optimistic response, we do not expect the result to materially alter the underlying market trend. Over the longer term, we can expect a more meaningful impact on index composition as a result of A-share inclusion. We estimate that complete inclusion of the 169 stocks would increase China’s weight in the MSCI emerging market benchmark by at least 8pp.
** Qualified Foreign Institutional Investor Scheme (QFII) or RMB Qualified Foreign Institutional Investor Scheme (RQFII
*** Asset under management
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