On June 9 MSCI announced that it is on course to include China A-Shares in its global benchmark equity market indices as soon as remaining issues relating to market accessibility are resolved. MSCI also announced that MSCI and the China Securities Regulatory Commission (similar to the SEC in the US) “will form a working party to contribute to the successful resolution of these issues.”
In brief, the issues outlined by MSCI relate to flexible and reliable access to quota allocations, liberalization of certain capital mobility restrictions, and recognition of clear title to ownership for ultimate beneficial owners. Interested readers can obtain the details here. The issues are substantial, but their resolution should be feasible in the context of the ongoing financial reforms and capital market liberalization in China. Both sides appear to be fully committed to achieving the inclusion of A-Shares in the global benchmarks. The main rival to MSCI, FTSE, has already announced on May 26 that it has decided to add China A-Shares to its global benchmark indices.
A further stimulus to an early positive decision by MSCI could be the start-up of the Shenzhen-Hong Kong Stock Connect program, which is expected in the fourth quarter of this year. This program will greatly increase the accessibility of the A-Shares listed on the Shenzhen market. That market represents some 41% of the total A-Shares market.
MSCI plans to construct a single China Index covering the integrated China equity universe, comprising A-Shares, H-Shares, red chips, P chips, and overseas-listed China companies (the latter is an important addition). The plan is to include progressive percentages of the A-Shares market in the index, starting with just 5% of the FIF (Foreign Inclusion Factor) -adjusted and free-float-adjusted market capitalization of China A-Shares. What that complicated statement implies for the widely used MSCI Emerging Market benchmark, EM, is the following: currently China has a weight of 25.3 % in EM; when MSCI first starts to include China A-Shares in its new China Index at 5% of its adjusted market capitalization, the weight of China in the EM Index will go to 30%. Interestingly, only 1.3 percentage points comes from adding the A-Shares; 3.6% comes from including overseas listed Chinese companies (e.g., those listed in the US) to the new China Index.
This first step, while significant, will not have a huge effect on the Chinese equity market. But planned subsequent steps will be of increasing importance. As China moves in a stepwise manner to further reform and liberalize its capital markets, MSCI intends to increase the inclusion factor in stages from the initial 5% up to, ultimately, full inclusion. When that point is reached, China will account for 43% of the benchmark EM Index. China A-Shares will account for 20.5% of the EM Index. There will be similar proportionate increases in the China share of other MSCI indexes that include China, among them the important benchmark All Country World Index, ACWI, and the All Country World ex USA Index, ACWX.
The most important effect of including China A-Shares in such widely used benchmarks will be the increased importance of A-Shares in the portfolios of international investors that use these benchmarks in their investment strategies. The resulting increased inflow to China's markets could reach $330 billion, according to some estimates. Of course, China's gain in the share of the global equity market will be offset by other markets losing share. Over the period until the A-Shares are fully included, India's share in the EM Index is projected to decline from 7% to 5.2% and Brazil's to drop from 7.3% to 5.5%. These are all estimates, and the actual results could vary depending on developments over the period. But the general direction is clearly bullish over the long run for Chinese equities as China's capital market becomes more integrated with the global market.
One negative implication is the likelihood that the benchmarks that include China will become more volatile once the volatile A-Shares market is incorporated with significant weight. Sizable swings in that market will have greater impact globally and particularly on emerging markets than the Chinese capital market now exerts. That volatility would be expected to moderate as the Chinese equity markets mature.
At Cumberland Advisors we are maintaining an overweight position for China in our International and Global ETF Portfolios. We regard the past week's correction in Chinese equities as a positive development. It was triggered by concerns about an increased volume of new listings and indications that margin requirements may be tightened. The mainland A-Share markets of Shanghai and even more Shenzhen had advanced too fast and some of the speculative froth needed to be reduced.