By Chin Ping Chia, MSCI’s head of research for Asia Pacific.

Chin Ping Chia, MSCI’s head of research for Asia Pacific.

Emerging markets may never be the same. On May 31, MSCI will include about 233 China large-cap A shares to the MSCI Emerging Markets Index. Inclusion at a 5% initial weight could lead to approximately $22 billion of capital inflows into these stocks. What might investors need to consider as we approach this milestone?

First, let’s look at the composition of the MSCI Emerging Markets Index. The China A shares that will be partially included to the index — large-cap mainland Chinese stocks that are traded domestically — will be added in two phases: half of their 5% initial weight will occur May 31, while the balance will be added in August. Historically, it has been difficult for many international investors to trade these shares, market accessibility has improved in recent years.

The initial inclusion will boost China’s proportion of the index by only 0.8%, to 31.3%, based on current values. But what if the Chinese market continues to liberalize enough to warrant full inclusion down the road? The A shares market is one of the biggest in the world, with more than 3,000 stocks traded. If full inclusion were to happen, China equities could comprise 42% of the MSCI Emerging Markets Index, with A shares alone accounting for about 16% of index weight.

Source: MSCI.

China would comprise 31.4% of the MSCI Emerging Markets Index at 5% inclusion as of August 2018 (left panel), based on data used for MSCI’s May 2018 Semi-Annual Index Review. At a hypothetical 100% inclusion (which may or may not occur in the future), China would comprise 42% of the index, based on the current market capitalization. All figures are approximate.

The inclusion journey

Five years ago, when MSCI floated the idea of adding China A shares to its mainstream indexes, global investors were unenthusiastic. This was because few were familiar with the Chinese domestic equity market even though the MSCI China Index (covering other share classes and Chinese stocks listed overseas) already represented the largest country by market cap in the MSCI Emerging Markets Index. Global investors were unfamiliar with this market because they were unable to access it.

China had cautiously opened its domestic A shares market to the world through efforts targeting institutional investors: the Qualified Foreign Institutional Investors (QFII) and Renminbi Qualified Foreign Institutional Investor (RQFII) programs. While these programs attracted some early capital, they failed to provide the minimum level of market accessibility needed by institutional investors.

Thus, the journey to inclusion was far from smooth and took years of effort. In addition to capital mobility restrictions and unequal market access under the qualified investor schemes, investors were uneasy about issues such as uncertainty of capital gains tax (2014), questionable beneficial ownership under the early phase of the Stock Connect program (2015), widespread voluntary stock suspensions (2016) and pre-approval restrictions on launching financial products (2016).

Despite numerous setbacks, Chinese policy makers and regulators made significant progress, addressing investor concerns one by one. Finally, when the Stock Connect program was expanded to include Shenzhen-traded shares in December 2016, it provided the breakthrough that global investors were seeking – a market that afforded open accessibility to all investors.

Source: MSCI.

Investors are preparing

Since MSCI announced in June 2017 that it would partially include China A shares in several of its key indexes, we have seen increased interest in investing in Chinese stocks by global investors as market accessibility has improved:

• The opening of Special Segregated Accounts, a proxy of international investors’ readiness and appetite to trade A shares, has surpassed 4,000 accounts, up from less than 1,700 since Stock Connect started three years ago.
• The total portfolio value settled through the Northbound Stock Connect reached RMB 520 billion ($84 billion) last December.
• More than 1,800 China A shares including those being added to the MSCI Emerging Markets Index are held by Stock Connect investors. Stock Connect is rapidly establishing itself as the primary channel to access A-shares.

Various efforts aim to avoid market bumps. For example, the People’s Bank of China (PBoC) quadrupled the Northbound Stock Connect daily limit to RMB 52 billion ($8.3 billion) and the Hong Kong Monetary Authority (HKMA) sought to ensure ample liquidity in the offshore RMB market (CNH) with a series of supporting measures. These actions underscored the regulators’ commitment to continue opening the market.

Looking ahead

As noted above, if the Chinese market continues to liberalize to the point of warranting full inclusion in the future, Chinese stocks — A shares and other share classes — could comprise more than 40% of the MSCI Emerging Markets Index. Additionally, should China A mid-cap shares ever be added to the index, Chinese companies would represent nearly one out of every two investment opportunities available to emerging-market investors. Institutional investors are devoting more time and resources to learning how to navigate Chinese markets.

The partial inclusion of China A shares may also trigger other important investment questions: How should investors evaluate the role of their emerging-market allocations as China accounts for a bigger slice of the index? How does the inclusion of A shares alter the fundamental characteristics of emerging markets? Would systematic strategies work well in China? Can the evolving ESG profile of A shares companies provide insight to investors? And, importantly, how should investors approach emerging market investing going forward? Investors will be seeking answers to these questions.

While emerging market country exposure may become more concentrated if China‘s exposure increases, the inclusion of A shares also may help open the doors to a part of China that was not accessible until recent years. This change may bring potential opportunities and diversification benefits.

(The views expressed here are those of the author and do not necessarily reflect those of ETF Strategy.)