China’s A-share MSCI milestone is more symbolism than substance

Wednesday’s decision by MSCI to include Chinese domestic stocks in its global benchmark equity index is a big deal, but not quite as big as it looks.

Symbolically, it’s enormous. After years of discussion and disappointment, next year A-shares will be part of the most powerful EM index in the world, one which is tracked by about $1.6 trillion of money.

People have had exposure to Chinese stocks for years through listings in Hong Kong and even New York, but this is the real thing: China in its unvarnished domestic glory, Shanghai and Shenzhen-listed stocks, collectively the second-largest equity market in the world.

However, it won’t make a huge difference to asset managers in practice, or not directly, anyway. MSCI is adding 222 A-share large-cap stocks. Between them they will represent just 0.73% of the MSCI EM index.

When one considers that China-linked stocks already account for 27% of the index through those Hong Kong and New York-listed stocks, the Alibabas and ICBCs and the PetroChinas, it doesn’t seem so significant.

The weighting might grow over time, but that will be conditional upon China making further steps to open the stock market.

For global investors, the decision to be zero-weighted in China, which has typically been the default position, is no longer an easy one to make

 - Rakesh Patel, HSBC

Based on the weighting on Wednesday, the change will attract $17.4 billion of demand for Chinese stocks from overseas, according to MSCI’s own numbers: big, but a drop in the ocean in the Chinese markets – and some think it will be lower: UBS Wealth Management expects $10 billion of net buying, and Tim Condon, head of Asia research at ING, $5 billion of capital inflows.

Moody’s expects that full index inclusion will follow in a few years and estimates that when that happens, A-shares would hold a 20% weight in the MSCI EM index. Now thatwould be significant.

“Full inclusion is key for China to attract fund inflows, which would benefit asset managers, spur renminbi internationalization and bolster investor confidence,” says Moody’s senior analyst Stephen Tu, but that will require a far greater demonstration of market openness and reform.

Knock-on effects

Even if that’s some way off, Wednesday’s news might have other knock-on effects.

Yannan Chenye, head of China equities research at Harvest Global Investors, believes the key is that it will help the A-share market to attract not just international investors but institutional investors, meaning a more balanced investor structure in China, and hopefully a market that behaves with greater reason than the retail-dominated one today.

“We expect fundamental-driven investment may gradually gather steam, and quality names with innovative business models, solid growth and transparent corporate governance will benefit,” she says. “At Harvest, we will gradually increase A-shares in our active portfolios.”

That’s a very long-term game, though.

Still, it’s progress, and it has come about because of the increased accessibility of the market through Hong Kong’s Stock Connect programme. Institutional investors – whose support MSCI required before making the change – have been encouraged by the programme and the access it brings.

The magic number of 222 that MSCI has come up with comes from counting up every large-cap A-share accessible through Stock Connect, minus any that are excluded due to trading suspensions. And the timing is something of a surprise, since there are still considerable questions around capital mobility and pre-approval requirements.

It doesn’t change much for active participants. Investors might like the idea of finding the next Alibaba among China’s A-shares before it ever becomes an H-share or a New York listing, but those investors were going to be in there regardless of the MSCI view. And set against that, there are real challenges about A-shares: questions of governance, enforcement and volatility.

“The number of trading suspensions in China’s A-share market remains by far the highest in the world,” notes Hyde Chen in the chief investment office of UBS Wealth Management. Right now, there are 100 A-shares suspended, worth more than 5% of MSCI’s China A index.

Shot in the arm

Inclusion might prove to be a shot in the arm for the ever-dwindling research teams of international banks: many will be expected to cover at least 300 domestic stocks in China for their clients – and several already do.

Certainly, the research teams in asset managers have been limbering up.

JPMorgan Asset Management has added four research analysts and two new portfolio managers to its Greater China team since the start of 2016 and plans to hire more. Analysts are also working out what will happen to the valuation gaps between A-shares and their H-share counterparts, a long-standing if unpredictable arbitrage opportunity (short answer: it should narrow).

Meanwhile, fixed income bankers are hoping their side of the fence might benefit from the symbolism of the moment. Index inclusion “should help keep market reform in China on track, and should support expectations for bond index inclusion too”, according to Citi.

If nothing else, global investors have a big call to make.

“For global investors, the decision to be zero-weighted in China, which has typically been the default position, is no longer an easy one to make,” says Rakesh Patel, head of equities for Asia-Pacific at HSBC. “We expect initial inflows will gather momentum and be substantial over time.”

Patel’s colleague Helen Wong, chief executive for China, calls it “the start of a process through which Chinese equities will achieve a prominence in global investors’ portfolios that reflects the size and significance of China’s domestic stock market and its economy”.