This article first appeared in Personal Wealth, The Edge Malaysia Weekly on July 3, 2017 - July 9, 2017

The gradual inclusion of the 222 large-cap Chinese stocks (China A-shares) on the MSCI Emerging Markets index is expected to have minimal benefit for retail and institutional investors — whether through direct investment or actively and passively managed funds — in the short term. But it could be positive for them in the long term if China continues to liberalise its economy and financial markets, say investment experts.

Gary Lim, regional fund manager of Apex Investment Services Bhd, says the limited impact is because China A-shares only make up 0.73% of the weightage of the index for now. While the inclusion on the MSCI Emerging Markets index, starting June next year, could attract new inflows into the A-shares (as more than US$10 trillion worth of active and passive assets globally are benchmarked against the index), the size of the inflows may not be significant.

“The market estimates that it will attract about US$17 billion to US$18 billion of new inflows into the A-share market. This is not significant as it is only about 1.3 times the daily turnover of the market,” says Lim.

He says fund houses that have taken an interest in China A-shares have already invested in the market via various channels. These include the Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect, Qualified Foreign Institutional Investor (QFII) Scheme and Renminbi Qualified Foreign Institutional Investor (RQFII) Scheme.

“The turnover of the A-shares market doubled last year, indicating that investors have already positioned themselves for the inclusion. Large fund houses have already invested in China A-shares and introduced funds dedicated to the market.”

Vasu Menon, vice-president and senior investment strategist for wealth at OCBC Singapore, also says the inflows into China A-shares will not move the market by a lot. “It is estimated that it will attract between US$11 billion and US$20 billion, which is not a lot compared with the daily turnover of about US$65 billion,” he notes. He concurs with Lim that large fund houses have already invested in A-shares through various channels.

In a media commentary, Helen Wong, chief executive for Greater China at HSBC, says the MSCI’s decision to include A-shares on its Emerging Markets index is a pivotal moment for global investment in China’s capital markets. “While the initial weighting is relatively small, this is the start of a process through which Chinese equities will achieve prominence in global investors’ portfolios that reflects the size and significance of China’s domestic stock market and economy. It will also provide impetus for the continuing internationalisation of the renminbi as a global investment currency.”

She adds that the successful launches of the Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect paved the way for the MSCI inclusion, and China’s commitment to liberalising global access to its markets will continue to create exciting opportunities for investors.

On June 20, MSCI Inc announced that it would gradually add the mainland China stocks onto its MSCI Emerging Markets index. This inclusion comes after three failed attempts.

According to MSCI’s press release, the decision to do so was due to the broad support it received from international institutional investors it consulted with. This is also a result of “the positive impact on the accessibility of the China A-share market of both the stock connect programme and the loosening by Chinese stock exchanges of pre-approval requirements that can restrict the creation of index-linked investment vehicles globally”.

The large-cap stocks that will be added onto the index include financial giants such as the Bank of China, China Merchants Bank and Ping An Insurance, according to MSCI. Other names include Tsingtao Brewery, SAIC Motor Corp Ltd and Suning Commerce Group.

MSCI Inc’s decision to include A-shares on the index has drawn criticism from some market players. One of the main reasons is that the Chinese capital markets have seen heavy intervention from the government in recent years.

“In fact, the China A-share market has experienced the highest number of trading suspensions in the world,” says Menon.

In January last year, China’s stock markets saw trading suspended when the Shanghai Composite 300 Index shed 6.9% following the release of weak manufacturing data. The Shenzhen Composite Index fell by more than 8%.

Three days later, trading was again suspended as the indices continued to plunge and the government called on large brokerage firms to support the markets. The move was criticised by institutional investors as they were unable to pull their funds out of the markets.

However, Menon welcomes the inclusion of the A-shares on the MSCI Emerging Markets index as there have been improvements in the past 12 months as the Chinese government reviewed its trading suspension mechanism. The index will not include the large-cap stocks that have been suspended.

Positive in the long term

Lim says investors should consider their exposure to Chinese stocks in the long term. He is positive on the country as it gradually opens up and liberalises its capital markets to meet international standards and make them more market-centric.

He adds that MSCI is essentially offering a carrot by having China’s capital markets integrate with the global market. By doing so, the Chinese government will have an incentive to reform its capital markets.

“Only a small percentage of China’s stock markets is held by foreign investors and the pressure put on the government by foreign investors could be minimal. There is also the possibility that A-shares could be removed from the index if its markets do not meet MSCI’s standards. This has happened to Pakistan before. However, the inclusion provides China with an incentive to be more market-centric,” says Lim.

He says there are positive signs that China will continue to reform its capital markets to meet international standards, which can be seen from the actions of President Xi Jinping at recent international events. For instance, Xi warned that the global economy could be at risk due to protectionist measures following the Brexit referendum — in stark contrast to the anti-globalisation and anti-trade rhetoric of US President Donald Trump.

Xi also announced China’s support for the Paris climate agreement while Trump said the US would withdraw from the accord.

Menon remains positive on China for the long term. He says Xi has made a lot of effort to reform the Chinese economy and open its capital markets to global investors. The QFII and RQFII Scheme, together with the Shanghai-Hong Kong Stock Connect and Shenzhen-Hong Kong Stock Connect, were implemented under his leadership.

“It is hard to tell if these will go on when there is a change in the leadership of China’s Communist Party. But as long as Xi implements all the necessary measures during his tenure and builds up momentum, things will likely be on track,” says Menon.

However, it will probably take a long time for Xi to reform and open up China’s markets. “He is tackling issues such as the country’s huge debt and property bubble. If he fully opened up the capital markets very quickly, it could trigger a massive capital outflow. This would hamper the government’s efforts to solve the big issues,” says Menon.

He adds that it could take up to 10 years for the full inclusion of China’s markets on the MSCI Emerging Markets index. He points out that Taiwan and South Korea took about a decade for their markets to be fully included on the index.

“The full inclusion will see China’s markets take up about 28% of the index’s weightage,” says Menon.

China H-shares will benefit

The H-shares of some of the dual-listed companies domiciled in China may benefit from the inclusion of China A-shares on the MSCI Emerging Markets index, says Gary Lim, regional fund manager at Apex Investment Services Bhd.

“Some companies in China dual-listed their shares in China and Hong Kong. It is the same companies being listed, but there is a gap between the valuation of the A-shares (which are listed on the Chinese markets) and H-shares (which are listed on the Hong Kong market). For instance, the Industrial and Commercial Bank of China’s H-share is about 15% cheaper than its A-share [as at June 23],” he says.

“Thus, when there are more investors looking into A-shares, they could see that some of the companies are also listed on the Hong Kong market and that the H-shares are traded at a lower price than the A-shares. So, investors could opt to buy the H-shares of these companies. On top of that, the H-share market is less volatile as the A-share market is dominated by retail investors.”

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