China's inclusion in the MSCI benchmark indices will lead to better sector diversification, and is a vote of confidence for China to further financial reforms and capital market development, says Mr Ronald Chan, Chief Investment Officer, Equities, Asia (ex-Japan), of Manulife Asset Management, in an investment note.
On 20 June, MSCI announced the inclusion of Chinese local equities, called A-shares, in its global equity indices (i.e. MSCI Emerging Market (EM) Index and MSCI ACWI Index), beginning in June 2018. The move follows three previous rejections.
The inclusion of A-shares in MSCI is expected to have several notable benefits on a gradual basis. In the short term, the A-share market may garner moderate capital inflows as funds that track the relevant index align their weightings; more importantly, sentiment is expected to improve, says Manulife Asset Management.
“In the medium to long term, we anticipate the weighting of A-shares in such an international index will be increased as the industries covered by A-shares are more diverse. The universe to choose from is much larger in the domestic Chinese market compared to that of Hong Kong. We also expect that foreign investors will need to pay more attention to A-share market developments as it becomes more relevant in a global context moving forward,” adds the note.
Internationally, over the long run, the pace at which an emerging stock market is included in the MSCI EM Index is related to the magnitude of liberalisation of its capital market. Markets implementing foreign exchange control are usually included in the MSCI EM Index on a gradual basis, which can take about seven to 10 years, says Manulife Asset Management.
Moody's Investors Service says that the MSCI inclusion is significant in that it will pave the way for global capital inflows into China’s A-shares by linking them to the most dominant trend in asset management – the increasing adoption of low-cost passive index funds.
The partial inclusion will start with an approximately 0.73% weighting of China’s A-shares in the MSCI EM index, which translates into approximately US$11 billion of near-term fund inflows into China’s onshore markets from funds benchmarked to that index.
The December 2016 launch of the Shenzhen Connect, which gave investors access to approximately 1,480 Shanghai and Shenzhen stocks with no licensing or quota requirements – and, importantly, no capital mobility restrictions – is a primary factor which made it feasible for MSCI to include A-shares, says Moody's. The Shanghai-Hong Kong Stock Connect was launched in November 2014.
MSCI had initiated the review of A-shares for potential inclusion into the MSCI EM Index in June 2013. Around that time, Chinese regulators began trying to open the onshore market further and allay investor concerns regarding capital mobility.
Prior to the Shanghai and Shenzhen Connect programmes, however, quota accessibility and repatriation restrictions remained persistent hurdles to wider investor ownership of A-shares. Last year, MSCI decided not to include Chinese A-shares in its EM index because of investor concerns about capital mobility. These issues have been partially allayed by the launch of the Connect programmes, which promote two-way capital flows into the local A-share market
To take advantage of these relaxations, MSCI's new index inclusion proposal will include mainly large cap companies that are accessible through the Shanghai and Shenzhen Stock Connect programmes. Although accessibility of A-shares and repatriation of assets remain concerns, the Chinese government continues to take steps to open up the country's markets.
Within its international indices MSCI has until now had limited China exposure, mainly through its exposure to Hong Kong and overseas-listed Chinese companies, and has not included equities in the onshore markets of Shanghai and Shenzhen. Now, funds tracking the MSCI EM indices will have representation from the world’s second largest domestic equity market by market capitalisation.
Accordingly, they will be better able to satisfy investor demand for broad-based index exposure to China’s economy and also enable investors to build additional strategies using the domestic Chinese market. This should lead to increased client demand and diversification benefits for investors.
Furthermore, increased foreign participation has the potential to raise corporate governance standards in China.
Moody's expects ongoing regulatory liberalisation in China’s onshore market to lead to a full index inclusion of A-shares in the next few years, with an estimate of a 20% weight within the MSCI EM Index. Full inclusion is key for China to attract fund inflows, which would benefit various asset managers, spur renminbi internationalisation, and bolster investor confidence.