China took a big step towards opening its domestic markets to international capital in February in a move that might win the A-share Chinese stock market membership of key MSCI benchmark indices.
The State Administration of Foreign Exchange (safe) made changes to the QFII programme, through which qualified foreign institutional investors can gain exposure to China’s domestic capital markets in dollars. The moves largely bring that programme into line with RQFII, which allows foreign investors access to offshore renminbi markets.
To anyone not involved in the minutiae of asset management in China, the moves may seem arcane: the introduction of a base quota registration system, for example, meaning the quota that asset managers receive will be based on their assets under management. But the impact will be considerable.
Z-Ben Advisors, the Shanghai-based asset management research group, says the moves “are monumental and bear similarity to those seen in the months prior to SDR inclusion,” when the People’s Bank of China changed the behaviour of China’s currency to secure membership of the Special Drawing Right structure of the World Bank.
The biggest impact may be the inclusion of domestic A-shares within the MSCI Emerging Markets index. MSCI began a consultation on this idea back in March 2014, but in June 2015 opted not to include the domestic market in its influential benchmark, citing problems with insufficient market access.
Will the changes be enough for MSCI inclusion? “That’s the million dollar question,” says Z-Ben analyst Stephen Baron. “If you look at their last consultation, the major impediments MSCI mention to inclusion,” specifically capital mobility, being able to get quota commensurate with fund size, and the issue of beneficial ownership, “have all been answered through this reform. From that perspective one would think it puts MSCI in a difficult spot in terms of the decision they have to take.”
MSCI has a precise roadmap in mind for Chinese inclusion in its indices, starting with an inclusion factor of just 5% of the market, which means that only 5% of the free-float market cap of A-share components within MSCI’s China Index would be reflected. If that happened, A-shares would make up 1.3% of the MSCI index, and China more broadly would be 30% (it was 25.3% at the time of MSCI’s announcement last June).
MSCI’s plan is that as China’s markets open, so its representation in the index would increase. Once the quota system is abolished and there is full freedom of movement of capital, China’s A-share markets would take their true weighting. Based on the MSCI’s review last year, China would then account for 43.6% of the MSCI Emerging Markets index, and Chinese A-shares 20.5%.
Clearly, then, any move towards this outcome is of enormous importance to any investor who invests in either the MSCI EM index or any fund that is benchmarked against it. And there are plenty of them: around $1.4 trillion is believed to track the index.
In its last review, MSCI said it would consider the first step of that plan, the 5% inclusion, in a May 2017 review. But the changes safe have made so exactly mirror what MSCI requested that it is possible the review will now be accelerated.
“Certainly this is something MSCI will have to review in 2016, as opposed to next year as originally planned,” says Baron. That said, MSCI will also consider market volatility in its decision and is ultimately guided by what its clients want.
Baron says MSCI inclusion is not the whole point of this round of reforms. “The overarching drive from the government and the regulators is the opening up of the markets here,” Baron says. “Obviously having MSCI inclusion is a big step in that process, but that is not the overall goal.”
The next step may be further liberalization of QFII to bring the last differences with RQFII into line. Under QFII, the China Securities Regulatory Commission requires a minimum 50% of allocation to go into equity; that restriction does not apply in RQFII, where a manager can be 100% fixed income if it wants.
Eventually the two programmes will be harmonized, if not actually merged, with two largely identical programmes, save for the fact that one will be in dollars and one in renminbi. Eventually, with full market openness, they will vanish completely.
Despite the shocking performance of A-shares over the last 12 months, considerable appetite for exposure remains. On the RQFII side, Vanguard received Rmb10 billion of quota last year and Rmb20 billion last month; on the QFII side, Fidelity has now gone up to $1.2 billion of quota. The maximum quota for QFII will now be $5 billion.
“For some managers, QFII will be of greater interest when it comes to the ability to get large quotas, particularly large firms like BlackRock who may have struggled to get $5 billion under QFII,” says Baron.