Mark Williams

MSCI indices: what does Chinese A share inclusion mean?

Mark Williams

The mainland Chinese A Share market is by many measures one the biggest in the world. The two mainland exchanges for A Shares, Shanghai and Shenzhen, have market capitalisations of US$3.9tn and US$2.4tn respectively (source: World Federation of Exchanges, 2018). This puts the country on a par with the world’s larger exchanges. In Asia, the Japanese exchange alone is bigger (US$5.3tn); Euronext, the largest exchange in continental Europe (US$3.7tn), is smaller than Shanghai; making the US exchanges the only ones with significantly greater scale (the NYSE and NASDAQ have respective market caps of US$21tn and US$10tn).


Mainland Chinese stockmarkets among the world's biggest


However, until 2017, these mainland Chinese markets were not represented in the major equity indices used by international investors. China’s representation in equity indices has historically massively understated its proportion of global economic output.


China massively under-represented in equity indices

China accounts for 3.4% of the MSCI AC World Index, similar to France (3.4%) and not far behind the UK (4.8%). The US accounts for over half of the index. This huge index weight difference between the US and China massively exaggerates the difference in the size of the their economies; the US economy is around 1.5x the size of China’s in nominal terms, and smaller in purchasing-power-parity terms. In other words, the ratio of the US’s share of the global equity index to its share of global GDP is 2.3x. China’s is a paltry 0.2x.


This disparity looks set to narrow. An MSCI index consultation in June 2017 saw A shares approved for inclusion at the fourth time of asking following ongoing improvements in China’s “market accessibility conditions”. Key to this improvement was the opening of the Shanghai Connect and Shenzhen Connect and the expansion of the Qualified Foreign Institutional Investor schemes.

The A shares have been added to the MSCI China Index, MSCI Asia ex-Japan Index, MSCI Emerging Markets Index and MSCI World Index.


Previously, on three occasions between 2014 and 2016, MSCI consulted on adding A shares to its indices but rejected the proposal due to concerns over issues such as stock suspensions and low capital mobility. The decision to finally include the shares came after significant improvements were made on the Shanghai and Shenzhen stock exchanges in (i) international investor accessibility and (ii) market interference.


MSCI chose to only include A shares at a very small fraction of their market value, to reflect the need to make ongoing improvements on these factors. So while the initial 2017 changes to MSCI indices were fairly negligible, the inclusion of A shares was symbolic, paving the way for full inclusion in future.


MSCI has, however, already increased the ‘partial inclusion factor’ it applies to A shares’ market value. This increase follows “overwhelming support” from international institutional investors. In justifying the move, MSCI cited a continuous commitment by Chinese regulators to improve market accessibility, which included a significant reduction in trading suspensions. Daily trading suspensions have averaged less than 20 in 2019, compared with over 200 for large chunks of 2018.


The reduction in suspensions or other means of intervention should be welcomed. During 2015’s heavy sell-off in the A share market the government introduced a raft of interventionist measures. These included the halting of initial public offerings, encouraging state funds to buy equities, forbidding certain investors to sell stock for six months and allowing companies to request their shares be suspended. Such attempts to ‘manage’ markets at moments of dislocation were a backwards step in our opinion – an important element of China’s economic transition should be the adoption of market pricing mechanisms – so we are encouraged that recent years have seen an improvement.


Following the MSCI’s increases, the latest of which is scheduled for November, A shares have taken on more significance in regional indices. They will account for 4% of the MSCI Asia ex-Japan Index, taking the total for Chinese equities (including B shares, H shares and other foreign listings) to 38%.


A share inclusion boosts China towards 38% of regional index

It seems inevitable that demand from international investors will drive MSCI towards significantly greater A share inclusion. Full inclusion would increase the value of A shares in the indices by around five times at which point China would account for near half of the regional index.

There are hurdles to overcome before we get there; MSCI has specified areas needing further improvement, such as the  a lack of A share derivatives (limiting risk-management possibilities) and the misalignment between mainland China and Stock Connect holidays, which creates trading frictions.


It will also take some time. South Korea was first included in MSCI indices at a partial weighting in 1992 and it was 1998 before full inclusion was reached. Similarly, Taiwanese stocks were first added in 1996 but didn’t reach 100% inclusion until 2005. 

 

Whether investors follow indices or vice versa, as long as China continues to open up accessibility to its markets and regulates them well, it seems obvious that international investors will increase their exposure to domestic mainland equities.

 

Assuming we get there, 100% inclusion for mainland Chinese equities would significantly change the role of China within investors’ portfolios in our view. Most significantly, we would anticipate increasing demand for stand-alone Chinese funds. This happened to Japanese Funds in the mid-‘90s, when ‘Pan-Asian’ funds were split up due to increasing demand for pure Japanese exposure.


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Key Risks

Past performance is not a guide to future performance. Do remember that the value of an investment and the income generated from them can fall as well as rise and is not guaranteed, therefore, you may not get back the amount originally invested and potentially risk total loss of capital. Investment in Funds managed by the Asia team involves foreign currencies and may be subject to fluctuations in value due to movements in exchange rates. The Fund’s expenses are charged to capital. This has the effect of increasing dividends while constraining capital appreciation. 

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Thursday, October 31, 2019, 11:31 AM