MSCI Inclusion Offers China’s A-Share Stocks Global CredibilityEquity Manager Research at Mercer Investments
The globalization of the world’s economy is taking a giant step forward. MSCI is opening the door to the world’s second-largest stock market: China. This development will create unprecedented opportunities and challenges as China and the international investment community nurture this new, remarkable relationship. The domestic Chinese stock exchange (Shanghai and Shenzhen) offers global institutional investors and hedge funds previously unexplored pathways to build value and generate earnings.
The Path Towards Global Credibility
China’s increasing prominence in the global market underscores the evolution of longstanding policies and cautious perceptions regarding the role of outside investors. The Mercer report, The Inclusion of China A-Shares In MSCI Indices: Implications for Asset Managers and Investors, chronicles the journey that China and the international investing community have made together to reach this historic agreement, and what to expect from a new era of growth and collaboration. Before the MSCI breakthrough, the primary mechanisms that granted foreign investors entrance to China’s domestic market were the Qualified Foreign Institutional Investor (QFII) and Renminbi Qualified Institutional Investor (RQFII) schemes, both of which were heavily regulated by rules and regulations limiting the types and sizes of organizations allowed to apply for a quota and their ability to repatriate capital.
Chinese authorities, however, have made opening the mainland equity market a key priority. Executing this innovative strategy required a disciplined and calculated approach to implementing change. China began by creating mechanisms to accommodate foreign investors. In December 2016, the Shenzhen-Hong Kong Stock Connect program was launched, providing foreign investors’ access to companies listed on the Shenzhen Stock Exchange. This forward-thinking initiative opened up the path to global influence and participation, with both China and the international investment community working together.
The Power of Patience and Compromise
Inclusion in the MSCI Index started with building trust and goodwill through shared interests and compromises made by both sides. The Shanghai/Shenzhen-Hong Kong Stock Connect programs—together referred to as Stock Connect—provided an additional quota to foreign investors and loosened burdensome restrictions. The relaxation of daily trading limits, continued progress on trading suspensions and further easing of regulations—in addition to the creation of new index-linked investment vehicles—led to acceptance by MSCI. China has illustrated its willingness to work collaboratively with the MSCI and the global investing community.
Investors with a material portion of their wealth invested in emerging market equities should consider how they can incorporate the expanding Chinese opportunity.
In return, the MSCI made several concessions to facilitate the inclusion of the China A-share market. Rather than slowing the process, MSCI offered a more aggressive and streamlined approach to inclusion. The MSCI’s lean but efficient strategy limits stock and country ratings and only allows international investors predetermined exposure in a particular market. These developments are just the first steps to a long journey. The agreement also serves as a powerful symbol for a promising future of growth and mutual prosperity. The weight of China A-shares in the broad market indices will have to increase over time. In perhaps five to ten years, Chinese A-shares can evolve from partial to full inclusion, much like the Taiwanese and South Korean markets did beginning in the 1990s.
The Way Forward for Investors
The MSCI acknowledges the volatility endemic to entering such a massive and complex economy. Managing expectations is critical to advancing the initiative. The first phase weighted only 226 stocks at 2.5 percent of their market cap, and the next phase increased the number of stocks by 10 and adds 2.5 percent, at a total of 5 percent of market capitalization. The MSCI is clearly taking a restrained approach to promoting growth and inclusion. Though the China A-share market has a number of appealing features, for investors with relatively small or straightforward equity portfolios, it would be quite reasonable to adopt a wait-and-see approach to the emergence of China. Other investors may choose to be more proactive.
Investors with a material portion of their wealth invested in emerging market equities, and those who seek to evolve their portfolio over time, should consider how they can incorporate the expanding Chinese opportunity within their broader equity allocation. A standalone allocation allows a higher weighting (than allocations dictated by the benchmark) with broader and deeper exposure to the market, enhancing both the return and diversification potential. However, investors must simultaneously address important risks and governance questions, especially considering the unprecedented nature of this developing scenario.
This piece first appeared in Voice on Growth.